Defcon status8/13/2023 The underlying hope that deposit rates would remain tethered while asset yields rose has not come to fruition. It’s worth noting that if institutions that consider themselves “asset sensitive” aren’t vastly outperforming, perhaps we should reevaluate the premise of asset sensitivity. Bank funding (including deposits, borrowings and debt) in 2017 increased almost five times as much as it did over the previous two years thanks to a flatter curve and a more rapidly rising absolute level of rates. Bank analysts debate daily the rate at which funding costs increase versus the absolute level of short-term rates change (or long-term rates). Heightened volatility alone may not spook markets, but the risk of unmet expectations and unexpected consequences may. That dynamic seems unlikely to revert, particularly if global pressures continue. Interest-rate volatility has increased more over the past 18 months than in the prior two years. But the possibility that we’ll sit closer to 2.75 percent on the 2-year if the 10-year hovers closer to 3 percent augurs poorly for many fixed-income managers, including bank managers. Rate levels aren’t necessarily the biggest concern. The OCC’s Semiannual Risk Perspective identifies among its key risks that multiple “rate increases could negatively affect credit affordability, performance, and asset valuations and influence refinancing risk, underwriting behavior, and credit terms.” This sentiment will sound familiar to those who have followed our most recent public missives on the subject, including on an article we wrote in May 2018. The specter of interest rate risk and convexity risk continues to be of significant concern for banks that have become very used to low deposit betas and accommodative Fed policy. The next piece of our DEFCON shift involves interest-rate volatility. Consequently, we’ve begun to see an uptick in delinquencies (see credit card and auto loans, in particular). To mollify investors, it’s easy to imagine loan officers loosening lending standards on consumer loans to offset this compression. And as consumer, auto and credit-card loan terms remain tight, margin compression-which many managers told investors would fade this year-will persist. Collectively, all bank loans generate 4.98 percent yields, according to SNL Financial, a number that will decline as more industrial loans replace consumer loans. Consumer and credit-card loans generate 9.11 percent yields, while commercial and industrial loans yield just 4.36 percent. This constitutes a problem for investors. Commercial and industrial loans, meanwhile, have picked up the slack, increasing by $56 billion over the same span (marginal sectors make up the balance). Those numbers have declined as senior loan officers continue to tighten consumer lending standards. Slowing loan growth may concern bank shareholders, but should it raise alarms from a risk perspective? Well, maybe, when we examine why it’s happening and what it could trigger.ĭigging into 2018 data shows that consumer loans have fallen by $18 billion, representing a 1.3 percent hit to domestic bank balance sheets. This equates to 0.80 percent growth, weak by almost anyone’s definition. But for domestic banks, loan balances have risen just $67 billion this year from a starting balance of $8.5 trillion, according to the Federal Reserve’s H.8 report. What’s more, many had expected loan growth to drive better performance. We’re almost halfway through 2018 and banks have underperformed in several areas. Now to be clear, this is not a dire announcement, but the current level also doesn’t indicate “a world at peace.” We have moved to DEFCON 4 from 5. We thought about it within the current landscape of financial risk, where there are troubling medium- and longer-term trends, including fundamental changes to regulatory regimes. Over time, DEFCON has seeped into the public lexicon where it’s been used to talk about threats that have nothing to do with defense.
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