When Fear Reigns Banking Majors GainIn times of crisis, investors rush to safety. When risk shows in places of safety, bank runs begin. One's pain is someone else's gain. Silicon Valley Bank (SVB) & Signature Banks' combined assets at $300 billion is witnessing a flight to safety.
At $300 billion, it is trivial relative to $23 trillion within the American banking system. Remember that the FDIC only insures deposits up to USD 250k. Both institutional and individual clients holding large deposits in regional banks are rushing to move their funds from regional to major banks.
Between 2020 and 2022, regional bank index outperformed the broader bank index. Regional banks business was designed to be lean - collect deposits and extend loans to home buyers and local businesses.
This was meant to be less risky relative to banking majors whose businesses were sophisticated and inherently risky. Hence the banking relief law passed in 2018, made regulations less onerous to banks with domestic assets of less than $250 billion.
As a result, by end of 2022, US had 2,100 banks with $19.8 trillion in assets. Only ten out of these 2,100 banks had domestic assets more than $250 billion.
Lax regulations led some regional banks astray with concentrated bets on customer segments and risk management of asset and liability maturity risk. With rates rising, tides receding, banks that were swimming naked became obvious.
Chart below contrasts the impact of unrealised losses on select US bank's tier 1 capital ratio. It is little surprise that SVB imploded with such an adverse capital situation when unrealised losses were accounted for.
Now as crisis of confidence in banking spreads across both sides of the Atlantic, depositors are rushing to move their money to larger safer bank and money markets.
FT reported on March 15th that large US banks are getting flooded with fund transfer requests from regional banks. SVB has triggered a tectonic shift in deposits unseen in more than a decade. Veteran hands know well that anxiety created by small shocks make larger crises less likely.
JPM, Citigroup are among the beneficiaries of regional bank pains. To aid customers to move deposits swiftly, these banks are taking extra steps to speed up client onboarding. It is reported that these banks are reassigning employees to account opening linked jobs to handle workload and to hasten the process.
HNI’s Shifting to Large Banks
Despite the liquidity backstop promise extended by US Fed and US Treasury, depositors are moving funds into larger banks such as JPM, Citi and Bank of America. This phenomenon is more so for accounts holding >$250k (the limit up to which is guaranteed by FDIC).
The 25 biggest US banks gained $120B in deposits in the days following the collapse of SVB and Signature while smaller banks saw a net outflow of $108B during that period. This has been the largest weekly decline in deposits at small banks and poses the risk of inciting more financial instability.
Citi’s private bank servicing wealthy individuals is opening accounts within a day compared to usual timeline of one to two weeks. Citi is reported to open accounts & initiate fund transfers even as new clients are under compliance checks.
Larger banks are subject to significantly tougher regulatory scrutiny as a result they become attractive destinations for shell-shocked depositors.
Portfolio diversification is not new. Long shadow cast by the debacle of three sizeable banks within a space of a week has exposed the fragility in the system. This has prompted depositors to diversify not only their portfolios but also their banks.
Moreover, comparing the actual assets held by large banks to mid-sized banks:
SVB and Silvergate, both of which collapsed had their assets largely held in bonds held to maturity or available for sale. For SVB, the maturity date was in the far future, posing liquidity concerns when a bank run ensued.
By contrast, Silvergate largely had bonds available for sale but selling them all at once would have caused huge realized losses.
Another interesting takeaway is the way in which each regional mid-sized bank adopts a different portfolio tailored for their specific clientele and their needs. Although, this allows them to fine-tune their operations and holdings, it comes with the downside of financial instability during periods of aggressive rate hikes and economic uncertainty.
By contrast, Citigroup, JP Morgan, BoA, and PNC have portfolios that are well diversified with a healthy mix of cash & interbank loans, loans, bonds to maturity, and bonds available for sale. Crucially, their significant cash holdings allow them to weather the storm far better and eases any liquidity concerns for depositors.
Capital Flow Towards Asset Managers
Large asset managers are also witnessing an influx of funds. Seemingly the money is moving away from regional banks and into majors and asset managers offering access to money market funds. Money market funds which hold US Government Debt are considered the safest destination for large amounts of fund given the overwhelming uncertainty in the banking sector. They also have the added advantage of offering investors seniority in case of bankruptcy proceedings.
Certain MMF’s are currently offering yields as high as 5.02% compared to a paltry 0.23% average for bank deposits, making the shift towards MMF’s a no-brainer for many.
More than $300B has flown into money market funds in March taking the overall assets in money market funds to a record $5.1T. This also represents the largest month of inflows for asset managers since the start of the COVID-19 pandemic. Goldman, Fidelity, and JPM are the biggest beneficiaries from these inflows.
Goldman’s US money market funds have increased by $52B or 13% since the beginning of the banking crisis on March 9th. JPM’s funds received $46B while Fidelity saw $37B of inflows according to data from iMoneyNet.
Capital Flow into Gold
Gold is one of the most prominent safe haven assets that investors look to in times of economic uncertainty and instability. This capital flow was seen during the 2008 financial crisis when bank deposits plummeted and Gold price skyrocketed.
The same can now be seen on an even larger scale. Commercial bank deposits have plummeted well below even 2008 levels while the price of gold is teetering around $2,000/ounce, the highest price ever.
Although, some gold investors choose to buy physical gold or jewellery, larger investors often opt for other instruments that are more cost effective such as ETF’s or Futures. This too offers the larger banks a huge opportunity to benefit from the inflow of capital into gold-linked products through their investment banking divisions.
GLD, or SPDR gold trust is the largest Gold ETF. It saw a net inflow of $915M in March. The same can be seen in CME’s GC futures which saw managed money traders increase their net long positions by 5x or 83k contracts ~$16B.
Trade Setup
This case study illustrates potential gains to be harvested from spread trades as funds move from regional banks to majors. With rates remaining elevated the majors enjoy a comfortable Net Interest Margin. Rising deposit base by cherry picking high credit quality customers will enable banking majors to vastly outperform the regional banks.
Therefore, this case study sets for three spread trades -
(a) Long JPM and Short KBWR (1:3)
(b) Long COF and Short KBWR (1:2)
(c) Long C and Short KBWR (1:1)
A spread trade requires that the notional values of each leg of the trade to be identical. Accordingly, the ratios above have been provided based on the closing prices as of April 3rd. Table below sets out entry, target, stop and reward-to-risk ratio for each of these trades.
Long JP Morgan & Short KBWR
● Entry: 2.82
● Target: 3.17
● Stop: 2.62
● Profit at Target: $16
● Loss at Stop: $9.5
● Reward-to-Risk Ratio: 1.7x
Long Capital One Financial & Short KBWR
● Entry: 2.08
● Target: 2.54
● Stop: 1.9
● Profit at Target: $21
● Loss at Stop: $8.5
● Reward-to-Risk Ratio: 2.5x
Long Citibank & Short KBWR
● Entry: 1.01
● Target: 1.19
● Stop: 0.937
● Profit at Target: $8
● Loss at Stop: $3.5
● Reward-to-Risk Ratio: 2.2x
MARKET DATA
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