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Regional Bank Tremors & Aftershocks 

A shot looking up at buildings during magic hour in a financial sector representing a podcast on recent regional bank tremors on wall street.
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On this episode of TD Cowen’s Thematic Outlook Podcast, Mario Mendonca, Senior Financial Services Analyst for TD Securities, and Jaret Seiberg, Financial Services and Housing Policy Analyst for TD Cowen Washington Research Group join Bill Bird, TD Cowen’s Head of Thematic Content, to take a deeper look into regional bank troubles

They discuss root causes, knock-on effects, and policy implications, as well as the experience of Canadian banks relative to U.S. regional and money center banks. They also discuss today’s “speed of money” and the power and ability of social media to act as a crisis accelerant.

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Transcript

Jaret Seiberg:

This has really become the GameStop moment for the US banking system.

Bill Bird:

Earlier this week, the US federal government seized and sold a third failing bank, First Republic. As is true every cycle, when interest rates rise, fragility and economic weakness are revealed. On today’s podcast, we explore the repercussions of the regional banking crisis, for US policy, for stress testing, and for CFO and treasurer behavior. And we look across the border to understand what it means for Canadian banks. My name is Bill Bird, head of TD Cowen Thematic Content, and our featured experts today are Mario Mendonca, Senior Financial Services Analyst for TD Securities, and Jaret Seiberg, Financial Services and Housing Policy Analyst for TD Cowen Washington Research Group. Jaret and Mario, welcome and thanks for being here.

Mario Mendonca:

Happy to be here.

Jaret Seiberg:

Let’s get started.

Bill Bird:

Mario and Jaret, what, if anything, do you believe observers may underappreciate about the current regional banking crisis?

Jaret Seiberg:

So Bill, maybe I’ll start and kick this off. I mean, to me, I think the biggest underappreciated aspect of this, how this has really become the GameStop moment for the US banking system. When we had the retail trading issues two years ago, everyone thought it was because these were relatively small companies and you had a lot of retail order flow. But I think what we really missed is that it really was the power of social media and the ability of social media to impact the financial performance of companies and how they trade.

And what we’re seeing is intense social media focus on a limited number of regional banks. A couple of them obviously had problems, highly exposed to uninsured deposits and risk of deposit or flight. But the reality is that banks are always illiquid. They always rely on deposits and turn them into highly illiquid loans, and no bank can survive a 20 or 25% deposit flight. And so I think what we’re really seeing are modern communications, modern trading, the ability to move money at the flip of a switch coming headlong into an industry that just is not set up or prepared for that type of experience.

Mario Mendonca:

From my perspective, one of the things that really stood out for me is that all of the ratios that regulators have our banks calculate, both in Canada and the US. These ratios were sort of built at a time before we really contemplated the speed with which money can move, as Jaret said. I’ll give you an example. The liquidity coverage ratio has you estimate stressed cash outflows, but there’s no element in the stressed cash outflows that captures the source of the deposit. Is it digital? Was it branch? So what I really feel we need to learn is that these liquidity coverage ratios and other ratios need to actually capture the nature of the deposit, not just whether it’s a retail deposit or institutional deposit, but even so much as how did you get that deposit? And I think regulation needs to adapt to the new environment.

So I’d say that’s the first thing that occurred to me, the point that regulation needs to a adapt to the new way deposits are gathered. The second thing that I think might be underappreciated is if you’re a treasurer or a CFO, you can’t unsee this SVB and First Republic demise. And what I mean by that, you can’t unsee it, you have to react to this, you have to react. And that may be holding more liquidity at the Bank of Canada or the Federal Reserve. It may be boosting your liquidity coverage ratio. It may be pre-funding in the wholesale market. And as behavior changes, as banks shift from focusing solely or predominantly on profitability and they shift that focus towards stability and security, there are implications for earnings. And what we need to learn, as investors and analysts, in the coming quarters is what are those implications and how long-lasting will they be? I think those are the two points I’d highlight as perhaps most underappreciated.

Bill Bird:

You’ve both touched on some of the root causes, the speed of money, the virality of social media, and how quickly the script can flip. Jaret, maybe fill that out a little bit more in terms of why didn’t Washington see the banking crisis coming?

Jaret Seiberg:

It’s not that it didn’t see the crisis coming. I mean, we’ve heard warnings about unrealized losses unavailable for sale securities for a while. I think what Washington didn’t appreciate was how quickly investor attention could turn and how quickly large depositors would react to the news. And it’s that speed that really caught regulators by surprise. If you look at a lot of the documents that came out in the recent congressional hearings, the Federal Reserve Bank of San Francisco was talking to Silicon Valley Bank about a lot of these shortcomings 12 months ago, 18 months ago. But normally banks have years to fix these problems and reform happens slowly. And I think if we go back to some of the lessons from this crisis, it’s that the traditional way of back and forth negotiations between examiners and bank boards, it just doesn’t work in a time when information moves so quickly and bank customers can react immediately.

Mario Mendonca:

One thing I’d want to add to that, Jaret, and candidly, I was almost irritated to watch this crisis unfold. It is no surprise to anyone that when interest rates go up, the value of your long-term bond portfolio will go down. That cannot be a surprise. It is the most basic of financial fundamentals, that a stream of cash flows will go down in value as rates go up. When I say candidly, this crisis sort of irritated me is if the value of your assets are going down because rates are going up, well then the value of your liabilities are also going down. Wholesale funding, for example, in theory that the value of the liabilities are also going down. So why did this become a crisis at all? It only became a crisis because of concerns that the banks would have to sell those securities.

And this goes to what Jaret was mentioning a moment ago. If you don’t light the fire or you don’t scream fire in a crowded theater, then there’s no need to sell those securities, in which case the decline of the value of the liabilities, the decline of the value of assets, they sort of offset each other from an economic perspective. The only reason why this becomes an issue is if you yell fire in a crowded theater. So I felt like it was uncomfortable to watch people fret about the decline of the value of the assets without also thinking about the liabilities.

Jaret Seiberg:

Bill, I think Mario really hit the nail on the head there because at the beginning I described this as the Seinfeld of crises, it’s a crisis about nothing, because the reality is that you can’t just look at one half of the balance sheet and say, “We’re going to mark half the balance sheet to market and we’re going to ignore the liability side.” And that wasn’t just with Silicon Valley Bank. I mean, we’re seeing that today. People are looking at other regional banks, they’re stress testing their loan portfolios to a severely adverse scenario like in the stress test, they’re assuming all the losses on their securities portfolios, but then they’re doing nothing on the liability side. And if you do that, of course a bank’s going to look insolvent, but that’s not reality.

Mario Mendonca:

Yeah. If I could just add one other thing to this. One of the emails I read from, it was an email that went to a client, it was from another analyst. And what the person had written, the analyst had written is that if the banks were forced to sell all their securities, they would realize these losses. And I almost fall off my chair because the ironic thing about that email is that if the banks were to sell all their securities, the unrealized losses would look like peanuts compared to the realized losses. So if you assume the bank is dead, then the bank is dead. And the point I’m trying to make here is the assumption itself is what causes the bank to fail. So the moment you start saying things like if they’re forced to sell all their securities, they would record these unrealized losses, it’s really a meaningless statement because you’re essentially saying they’re done, because if everybody’s rushing to the exit at the same time, the unrealized losses are peanuts compared to the realized losses.

Jaret Seiberg:

Yeah. And to follow that up, the Fed came out with really an unprecedented program in which they’re saying you can pledge all your government and agency securities at par. It doesn’t matter what the rate is, you can pledge them at par for liquidity. That should eliminate any need for any bank to sell it’s available for sales securities or God forbid, their held to maturity securities in response to a liquidity run. And yet you still see analyses out there of people assuming that banks are going to have to liquidate these portfolios and take these losses.

Bill Bird:

I want to get into some of the regulatory actions in a moment, but before we go there, Mario, it would be helpful to get your perspective on the Canadian banks. What has been their experience in this crisis? Have they experienced the runoff in the US businesses like the US regionals, or have they been beneficiaries like the money centers?

Mario Mendonca:

Well, Canadian banks, first of all, let’s separate Canada from the US. The deposit runoff that is evident in the US has not played out in Canada. And it might simply be that quantitative easing, which was what drove this significant increase in deposits, was not as robust in Canada as what we saw in the US. Certainly our Bank of Canada balance sheet moved a lot higher, just as what we saw with the Fed balance sheet, but we didn’t have the same level of quantitative easing in Canada. It stands to reason then as we go through our quantitative tightening, we’re not going to see the same deposit runoff in Canada. And so far, although Canadian data is delayed relative to what you folks get in the US, we’re not seeing any deposit runoff for the Canadian banks. Now, for our Canadian banks that have large operations in the US, we are seeing deposits shrink relative to where they were a year ago.

Every bank is, that is just the nature of quantitative tightening. But what I think is really important to highlight is our Canadian banks did not see any of the panic runoff of deposits during that stressed period of March. Would I call them the JP Morgans? No, I don’t think our banks were net beneficiaries, but I can say with some confidence, and this is frankly from having spoken to them directly throughout March, that’s what you do when you go into these panic periods, is our banks did not see any aggressive deposit outflows during that March period in their US businesses. But to take it one step further, other than a few banks in the US, most deposits, as these US regionals have reported of the last few weeks, they actually look pretty good. This does seem rather isolated to a few banks, so to call this even a crisis might even be a bit of an overstatement.

Bill Bird:

Jaret, let’s shift gears to the regulatory context. What do you believe are the regulatory implications of what’s happening to the US regionals and what does it mean for bank stress testing going forward?

Jaret Seiberg:

Yeah, I mean, I think the old way of trying to correct behavior at banks has to be thrown out the window. It just doesn’t work, it takes too long, it’s measured in years, not months or weeks. And given the speed of money today and the speed of social media, it’s just no longer effective. That’s why I think you’re going to see a return to relying on the stress test to really change bank behavior. I expect the Federal Reserve in the next month or so is going to overhaul the annual stress test. There’s going to be many more scenarios and sub scenarios, including an interest rate risk scenario. And they’re going to use essentially public shaming to convince banks to modify their behavior much more quickly. The theory is no banks wants to fail the annual stress test or any component of the stress test, and therefore they’re going to change their balance sheet much faster than if they’re just having discussions with examiners.

Mario Mendonca:

Something interesting is happening in Canada from a regulatory perspective, our regulator, the OSFI, the Office of the Superintendent of Financial Institutions, they put out their 2023, 2024 outlook and moving into the number two spot of their nine risks, number two was funding and liquidity. Number one is always the housing market in Canada, that’s the perennial favorite whipping boy in Canada. So number two is funding and liquidity, the first time it appeared as the number two risk for our regulator. And in that document, the regulator says that they’re going to intensify their review of liquidity and funding. That’s an important statement from our regulator. They go one step further and say they may introduce new liquidity and funding requirements and then they use the word I hate to hear and see in these documents, is the rules may be imposed in a non-public manner.

Jaret referred to public shaming, in Canada, we never do that with our banks. In Canada, what happens is everything happens behind the scenes, as an analyst and an investor, certain changes and behavior changes among our banks, and we never understand why until much, much later. Everything seems to happen behind the curtains in Canada, but our regulator has taken a shot across the bow and let our banks know that they will be looking at liquidity and funding a little more intensely than they have in the past.

Jaret Seiberg:

Hey Bill, if I could add to that, one of the biggest changes during the Trump administration when it comes to bank oversight, was elimination of the qualitative stress test in addition to the quantitative stress test. And that qualitative stress test really looked at how bank management runs the bank and how they manage for risk. And the loss of that tool, I think, really hurt the ability of the regulators to pressure the banks to move quickly. It’s a big hurdle to bring back the qualitative side of this test, but I would be looking for that. I certainly think that that’s back in the realm of possibility now, just given everything that’s happened.

Bill Bird:

Let’s shift gears and talk about treasurer and CFO behavior. Mario, you’ve covered the sector for two decades plus. How do you think recent events will change treasure and CFO behavior going forward, and are there earnings implications

Mario Mendonca:

If you’re a Canadian treasurer, CFO or frankly US or Canadian, you cannot ignore what you just saw with SVB and First Republic, and you can’t ignore what our Canadian regulator has said about intensifying the review of liquidity and funding. So the ways you react are you shift from focusing predominantly on profitability, you shift toward security and safety, and that could be things like pre-funding in the wholesale market. You don’t want to be shut out of the wholesale market if there’s a period of stress, so you fund as early as you can, even if that means you have to pay up. I think you hold more cash at your Central Bank, Bank of Canada, Federal Reserve, you probably slow loan growth somewhat. You do everything you can to increase your liquidity coverage ratios because you want to look good to your regulator and also practically, you want to have a lot of liquidity.

All of these things have implications, and I think the key implications would be your balance sheet doesn’t grow as quickly as it used to. Historically, Canadian bank balance sheets grow at about 7% a year. It would have to be something less than that. And your margins, our Canadian banks have seen their margins increase over the last few quarters smartly, and I think the same things happened with the US regionals. But look what happened to US regional margins, after being up 25 basis points sequentially for the last three quarters, margins were down about five or six basis points for the US regionals when they reported their Q1 ’23 results. That’s the sort of thing that you might see in Canada. Margins flatline, possibly declined a little bit, and that’s been an important driver of earnings growth. So the key implication is as you shift from profitability to safety and security, you boost your ratios, but you lose a little bit of earnings momentum.

Bill Bird:

Let’s shift to deposit insurance. Jaret, can Washington realistically establish unlimited deposit insurance to put worries over regional banks to bed?

Jaret Seiberg:

Okay, so that’s really a two-part question. The first part is, would that even put worries to bed and I’m not sure it would. You have some banks right now that are still under pressure even though they report liquidity in excess of 150% of their uninsured deposits. In other words, all those uninsured deposits could leave and the bank would still be up and running. But let’s put aside that question and get to the broader policy question, which is could we even get to unlimited deposit insurance? And the short answer is, I think not in this current environment. I think the closest we can get is what we have, which is an implicit deposit insurance system in which the government has effectively said that any bank that fails in the coming months because of this crisis, is going to be deemed systemic and they won’t let uninsured depositors lose any money.

And in fact, nobody at Silicon Valley Bank or Signature Bank or First Republic has lost a penny in deposits. Getting a more formal deposit insurance program, something similar to the TAG program from the financial crisis, that would require an act of Congress. There’s two ways to do it, either Congress passes legislation the old-fashioned way, which is virtually impossible in this highly partisan environment with control of both chambers so narrow. The other way would be for treasury, the FDIC and the Federal Reserve to deem essentially a financial or systemic event and to send a resolution to Capitol Hill to authorize a short term unlimited deposit insurance program. That can’t be filibustered in the Senate, and so it means that it could have a shot to pass. The reason they haven’t done that is they fear a replay of TARP, where all aye, were on Congress and would Congress pass TARP? And as it became clear that the TARP vote during the financial crisis would fail, the market started to plunge and they don’t want another high profile vote like that because they think it could backfire on them.

Mario Mendonca:

I’ll leave the policy commentary to Jaret, but what I can offer is that nothing’s free. There is a cost to all of this government support. In the case of deposit insurance, we’re seeing materially higher deposit insurance assessment costs, every bank talked about it in their calls, you can see it in their results. And in Canada, again, under the caption of nothing’s free, the Canadian government has introduced a number of tax measures to essentially claw back some of the support that they offered, not to the banks directly, but to the bank customers. So it really does fall under the caption of nothing’s free in this world.

Bill Bird:

Jaret, what are some of the other policy initiatives you’re watching that investors will want to pay attention to?

Jaret Seiberg:

Sure. So I mean, I think we have a significant regulatory revamp that’s coming down the pike, that includes implementing the final phase of Basel III, sometime known as the Basel III endgame. We’re expecting to get that proposal in June. That’s sort of the last step of the post-financial crisis capital overhaul. I also think you’re going to see a lot more focus on the regional banks and how there regulated. There was a pullback coming in 2018 when we adopted the tailoring rule to try to dial back some of the oversight of the regional banks. But given that the regionals were the focal point for what’s been transpiring over the last month or so, that is going to change. The comptroller of the currency, Michael Hsu, has been pushing for TLAC for regional banks. TLAC is a type of unsecured long-term debt that can help if a regional bank gets into financial distress.

I think you will see that get pushed down to banks with up to a hundred billion of assets. And then I think you’ll probably see some changes on the resolution planning side as well. There’s a thing known as single point of entry, it’s designed to make it easier to sell off parts of a bank if it gets into trouble. That currently does not apply to the regionals and I think you’ll see that get pushed down to them as well. And then finally, there’s going to be a look at the available for sale securities portfolios. I do think you’ll see them treated similar to the US GSIBs, which are the largest banks, in that unrealized gains and losses will get reflected in capital. And I expect you’ll see a lot more regulatory scrutiny of the held to maturity portfolios to ensure the bank really does have the capacity to hold those securities until they mature.

Mario Mendonca:

Sorry, there is a Canadian element to this. Our Canadian banks, at the top of the house, their consolidated balance sheets and their capital ratios do reflect the unrealized losses unavailable for sale securities, it does. But their US regulated entities do not. So our Canadian banks are like the regionals and not the GSIBs in the US. So say take one of our Canadian banks, BMOs big US business, that US business, the capital ratio does not reflect the unrealized losses associated with their available for sale securities accounts. So if those standards do change, as Jaret suggests, it will affect our Canadian banks. Now here’s the interesting thing, if the top of the house already captures the unrealized losses, but the US business doesn’t, then what’s the remedy? The remedy would be to allocate capital from the top of the house to the US operating company.

So I don’t think this would involve our Canadian banks having to raise equity. It’d be more of an allocation of capital from one place to another, because the top of the house, the consolidated entity already captures the unrealized losses. The final point I’d make is if we’re going to make changes of this nature, if the regulators are going to make changes of this nature, they had better phase this in. I don’t think you want to impose changes to AFS or certainly not held to maturity securities, you don’t really want to impose those changes abruptly. I don’t think the capital ratios could stomach that.

Jaret Seiberg:

Yeah, I think Mario’s last point is spot on, and in fact, there could be such a long ramp up for this that those unrealized losses actually become unrealized gains, or at least may end up being neutral. So this could end up really by the time it’s fully implemented, not having much impact on the banks themselves.

Mario Mendonca:

But just think about this for a moment, if you’re a money center bank or a large Canadian bank in the US and you know that over time you will have to report your unrealized gains and losses associated with available sale securities in your capital ratio, you may change how you invest your excess deposits, because in the US the math is pretty simple, deposits are far greater than loans. So you take the excess deposits, you invest them in something. If you don’t want significant volatility in your capital ratio arising from significant changes in interest rates, well then you have to invest in short-dated securities. And now if you invest in shorter dated securities, then aren’t you impacting your net interest margin? So changes in regulation, even if they’re phased in, could have implications for profitability down the road. There could be meaningful implications for investors in the regionals if these changes are forthcoming.

Bill Bird:

Before we wrap up, Mario, what are some upcoming TD Securities events related to banking and financial services that are worth highlighting?

Mario Mendonca:

Yeah, there’s one big one in London, England on June 19th and 20th. I host all of the Canadian bank CFOs for one-on-one meetings with international investors. This year I’ve asked the Canadian life insurance companies and the P&C insurance companies to join us. So it’ll be quite a few banks, insurance companies, CFOs with me in London, England, June 19th and 20th. That’s the big one I’m doing this year.

Bill Bird:

Mario and Jaret, we’ve covered a lot of ground today. Thanks for an excellent discussion. I look forward to checking in with you both in coming months to see how things are progressing. I also want to thank our listeners, we appreciate you and we look forward to getting together for next month’s episode. Be well and see you next month.


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