Pain in the Deposit

Imagine a United States mostly poor.  If the sun rose in the West, would there be a San Francisco Post writing funny headlines?  Is it possible to pose a single, fantastical change to history or physics without undermining the paradigm of what is considered normal?

This is the disruption posed by negative interest rates.  For those that don’t follow banking all the time, the current risk free rate of interest in Europe is -0.4%.  In Japan it is -0.1%.  In the United States the current risk free rate is 0.5% and at the moment the trend is rising.  Some believe it is only a matter of time before a weak world economy drags the US down forcing rates to fall and perhaps even go negative.

Negative interest is not intuitive to most people.  We have a little money and you want to borrow it, so you agree to pay us back next year less a small amount.  Thank you very much, but we will keep our money.  Except maybe we can’t.  Liquid money is mostly in bank accounts, treasury bonds, money funds and repos.  Negative interest can be imposed by central banks, because holding large amounts of currency isn’t practical.  This isn’t really negative interest.  It is more like a tax imposed on investors that prefer safe, liquid holdings.  Raise the fee high enough for long enough and these investors will start to vanish.

What else may change with negative rates?  Most bank branches will close.  With rates below zero, it doesn’t make sense to pay for branches.  Even today bank branch expense is really an “option” on the probability that branches will be profitable in the future.  Banks already have begun closing branches, but with ZIRP (“zero interest rate policy”) and the march of technology, how far can a tipping point be for a rapid acceleration to this process?

Central bankers aren’t thinking about such things.  Every major economy in the world still has some inflation.  Since short term rates and inflation have tended to be equal in the long run, ZIRP is the continuation of financial repression (central bank favoring of borrowers over lenders) in hopes of stimulating the economy and future inflation.  ZIRP isn’t normal, but it is being used in the hope of getting back to what we think of as normal.

The market recently took the implication of negative interest very seriously.  The Federal Reserve used negative interest in the 2016 stress tests of the major banks.  This set off a massive Wall Street modeling exercise.  The outputs likely made it around to most of the large mutual funds and hedge fund managers.  The January sell-off in bank stock prices suggests they didn’t like what they saw.

Consider for a minute the possibility, if not the probability, that the US will descend to negative short term rates like the Europeans and Japanese.  In the banking business model, interest income declines due to rates are usually offset by lowered funding costs.  The large banks, however, are near zero in their funding costs.  To maintain spread they will need to charge deposit customers through negative interest.  But will they?  We have seen money funds not charge management fees due to ultra-low rates.  Banks may behave similarly.  There will be an unwillingness to risk alienating the deposit customer.  Banks will suffer in the short run as an “option” to retain the customer for better, normal times.

Central bankers would have us believe negative interest rates are just one more step on a continuum.  Maybe, but to use a math term that has become an overhyped tech word, our feeling is zero interest is a singularity.  On the other side of zero is a completely different and alien financial structure incompatible, rather than complimentary, to our “normal”.

On March 10 the European Central Bank showed some understanding of this problem.  The ECB decided to lend to banks at negative rates for extended periods, but only if the banks increase lending to consumers and businesses.  The policy recognizes the “tax” imposed by negative interest rates on the banking business model and seeks to incent bank lending at rates that otherwise could never make sense in the confines of the business model.

It might work.  The incentive is clearly there to push fresh funding into the marketplace at even lower nominal rates, which should help existing borrowers and maybe will pull forward some new borrowers.  Longer run if true growth and animal spirits aren’t induced by the new round of stimulus, it is easy to see a Japanese scenario of high liquidity and a torpid economy.

The ECB’s policy choice grasps the diametrically opposed regulatory forces in banking.  Ever higher amounts of capital, liquidity, stress testing and compliance are leading to “less banking” with an inevitable impact on the economy.  The goal of central bank accommodation is “more banking” to generate more economic activity.

There are implications from what the ECB has done here in the United States.  As noted earlier our most recent round of stress testing included negative interest rates along with the usual assumptions of a very difficult recession.  The stress tests probably didn’t take into account the likelihood that a Federal Reserve responding to a collapsing economy might move the goal posts by lending generously for extended periods with negative rates.  What is the use of modeling a world as if the Federal Reserve won’t act in the interests of the economy simply to justify a higher capital regime?  If you model a world where the banks can’t earn, then even doubling capital isn’t going to look very safe.

The logical end of stress testing has been reached.  End of the world modeling incites regulatory pressure such that the end of the world becomes more likely.  The stress tests and the accompanying living wills have become the albatross of large bank investment value.  Normally companies earning good money defend themselves from excessive pessimism simply by repurchasing shares or raising dividends until the melancholy passes.  The stress test process handcuffs the banks and assures there will be price volatility and little risk taking.

At least community banks are in a better position.  Deposit costs are still between 40 and 80 basis points for much of the segment and the yield on earning assets is higher than at large banks.  There is still room to cut a little on funding costs.  The Fed’s obsession with large bank liquidity doesn’t extend to community banks.  Many are running balance sheets with loans equal to 80% of assets.  There are even some with 90%.  Given the current interest rate environment and accounting conventions, the closer a community bank gets to 100% loans, the better off it is.  There is more credit risk per dollar of capital, but also more earnings.

Still negative short term rates could unsettle the community bank business model.  Loans are frequently priced taking into account mitigating deposit balances.  Will customers who only deposit, not borrow, become the dividing line between those who must “pay” to deposit.  What benefit are escrow deposits or other short term, variable money if there is no corresponding short term asset with some yield?  The stickiness and relative cheapness of core deposits is a primary element of bank valuation.  A bank’s franchise value is suspect if deposit relationships are near worthless.

Similar to our shale oil producers with a singularity at $30 barrel, banks face disintermediation on the other side of zero.  Banks are only special because they can gather deposits.  Lending is a byproduct of the opportunity to do something useful with the deposits.  In the absence of a rationale to deposit, the result is not negative interest, its less banking.

For many this might be a good thing.  Too big to fail and systemic risk are the catchalls of regulators and politicians.  Less banking could be just what the doctor ordered.  However, unless the activity of banking is replaced, less banking is less economic activity.  The large banks in Europe are retrenching and the economy is stalled.  Does the stalled economy reflect a shrinking bank sector or the other way around?  It’s not easy to stipulate causation.

Our feeling is that for the US at least, the pessimism is overdone.  The economy is performing and credit conditions remain very easy in part because long term rates have not followed the Fed’s lead and risen.  Large banks suffering from regulatory overreach is not a new story.  Community banks should take advantage of the still robust economy to get their scale and efficiency to levels where they earn their cost of capital.  Also increasing the scale of mortgage, wealth and other fee income source can provide balance against spread compression.  Given the difficulties we are seeing overseas, the only real defense against troubled times is core earnings and this is something that community bankers can still control.

Jonathan Holtaway

Jon Holtaway is an expert in the banking sector and has been quoted in national publications such as The Wall Street Journal, The Financial Times and The Washington Post. As a hedge fund manager and former investment banker, he has dedicated his career to investment analysis and building relationships in the banking sector. After spending twelve years with a premier regional investment house, Jon has co-founded two companies and has extensive experience working with wealth management and residential mortgage companies. Jon serves on the board of a publicly-listed community bank holding company, Hawthorn Bancshares ("HWBK"). In his free time, he is a passionate reader and writer. He authored “The Growth Penalty: Unfinished Business, Banking and the American Recovery” in 2013.

Jacques Rebibo

Mr. Rebibo has been a community bank investor for over 30 years. He entered the banking industry in 1985 when he invested in and joined the board of a de novo bank, Fairfax Bank & Trust. In 1999, Mr. Rebibo was an organizing director and subsequently became Chairman for nine years of Access National Bank, which grew to $3 billion assets before selling in 2018. In 2009, Mr. Rebibo co-founded and was Chairman of 1st Portfolio Holding Corporation, a residential mortgage and wealth management company. 1st Portfolio was sold to WashingtonFirst Bankshares, “WFBI” in 2015.


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