Every bank needs to reassess to their strategic and capital plans because of this past week’s events. Optimizing self-sustaining liquidity levels and real capital levels should be the highest priority right now.  

This is a preliminary report on the potential issues that are likely to directly affect community banks because of recent bank failures.  As the dust settles, these issues will be further clarified and quantified. This message is not intended to delve deep into the specific issues that affected the banks in question, but to focus on the potential implications of the pressures that would be felt by the community banking market in general and our clients specifically.

The headline is this:  Given the shift in current conditions, Liquidity is Now King!

Tipping Point

It is clear to all that the banks involved in the present crisis already suffered from financial fissures created by their asset liability management, investment philosophy and overall liquidity management. However, by themselves these weaknesses were not sufficient to result in their failures. There are many banks with severe AOCI issues that might not face such a scenario. However, these affected banks had one feature in common with each other. It is this feature that was primarily responsible for tipping-the-scale for these banks.

All these banks had a concentration within a specific industry segment (Start-Ups and Crypto). This industry concentration made them vulnerable to the vagaries and characteristics of these segments. In the case of start-ups, the closely knit VC-influenced community reacted simultaneously, creating a run on deposits and the bank's equity in an overreaction to liquidity issues. In the other case, the disruptions in the crypto market including the bankruptcy of a major player provided the tipping point for the bank that concentrated on that marketplace.

The experience highlights the increasing vulnerability of community banks with existing and potential AOCI issues to disruptions in their regional economy and/or industry concentrations. This also emphasizes the need for community banks to shift towards analyzing the economic characteristics of their footprint and its dependence on potentially vulnerable and regionally-dominant industry segments. The traditional focus on loan category performance and concentration can be misleading due to the amorphous distribution of these loan categories across different industry segments.

Future Ramifications for Community Banks

1. Increased regulatory focus on community banks. This is now inevitable and regulators will be focusing aggressively on community bank liquidity issues as well as redefining capital adequacy guidelines and limits. These new constraints will be applied, typical to regulatory actions, across the board and it would be up to community banks to defend themselves from the regulatory blanket potential overreaction.

The recent government actions and guarantees can be politically debated, however it must be recognized that their decisions were made in conjunction with critical information provided by the Fed. The Fed in turn has the best and most up-to-date information on the liquidity issues prevalent in the community banking market and the potential extent of the problem. Their concern regarding real liquidity issues across the community banking market must be taken seriously. Regulators and investors are factoring this into their capital calculations; banks can no longer hide behind accounting and regulatory capital opt-outs.  

2. AOCI problems will be highlighted and underscored. Unfortunately the problem will expand beyond AFS securities into the unrealized losses embedded in the HTM portfolios of community banks.  Capital planning and management must include this impact moving forward. 

3. Increased political and governmental attention on the FHLB and its role and mandate could change or restrict its ability to act as a resource to community banks. Expect more pressure on the FHLB since their seniority on the liquidation preference ladder conflicts with the FDIC’s implicit guarantee of all deposits.  Banks will need to become more self-sufficient with managing liquidity.  See point # 6 for more elaboration.  

4. Despite the drop in interest rates across the yield curve on Monday, monetary policy is likely to remain tight.  Inflation is not even at the half-way point between the 9 percent peak and the 2 percent target.  The fed funds rate could easily have a six-handle on it at year end and quantitative tightening will continue to vacuum deposits out of the banking system and force banks to become increasingly competitive with money market funds and the U.S. Treasury.  Any reversal in monetary policy will simply reflect a shift in focus away from liquidity and interest rate risk and towards credit risk because it means we are in a deep recession.  

5. Given the restrictions -- existing and building -- within the liability side of bank balance sheets, community banks will have to focus attention on the asset side to address potential issues.  Deleveraging, as distasteful as it might be, might be the only solution to many banks. If applicable, Management needs to educate their boards on why this maybe a prudent strategy instead of prioritizing growth and profitability.  Here again, the tremendous risk and yield diversity across industry segments within specific loan categories would be critical in managing deleveraging without constraining profitability. Properly structured capital adequacy tests performed across industry segments have more than verified the widely varying capital requirements of identical loan categories made across different industries. This further emphasizes the need to expand analytics to a bank's industry exposure.

6. The adaptation, in advance of specific regulatory changes, in stress testing techniques and methodology is going to be critical to all banks as they enter this period of turmoil and uncertainty.  There should and, will be, an increased focus on Liquidity Coverage Ratio (LCR) calculation.  This possibly is the most powerful tool for banks to measure self-sustaining liquidity as well as pre-empt regulatory concerns.  Now more than ever, up-to-date liquidity and capital adequacy analysis have become a strategic necessity rather than a regulatory exercise.

7. The M&A market will go through a meaningful disruption.

• Transactions will temporarily decrease while banks analyze the implications of fed actions and new regulatory pressures.
• There will be a meaningful increase in "desperation" sales by affected banks and possible FDIC involvement in the sales.
• Acquisition due diligence will now increase focus on both buyer and seller liquidity, capital adequacy and very importantly industry exposure/concentration.
• Overall shift in bank stock prices will affect acquisition multiples.
• Overall valuations will be subject to downward pressure across the community banking marketplace.

As always, Invictus with its cutting-edge analytics, data and resources will continue to rapidly adapt its services to extant conditions so that we can provide our clients with the information necessary to navigate through these conditions.

We founded Invictus in October 2008 because we believed the banking industry needed a different mindset and toolbox at that time.  We showed our agility to repeat this again in March 2020.  And now we are ready to do it again with you again in March 2023.

Live Webinar | April 5th, 2023 11AM ET

In this session, we will introduce community banks to the Liquidity Coverage Ratio (LCR), which is the best measure of liquidity that exists in the banking system.  Large banks are required to calculate it on an on-going basis.  While not a requirement for smaller institutions, the fallout from the recent failures of SVB, Signature Bank, and Silvergate combined with the impact that tightening monetary policy is having on the money supply underscores the importance of calculating this ratio and adjusting your strategy to optimize it if need be.