Thursday, February 01, 2024

How Did Banks Fare During Fed Tightening?

Now that the debate is turning from Fed tightening to when the Fed will start dropping rates, we took a look at how financial institutions fared during the tightening cycle, using the quarter ended December 31, 2021 as the base period. The Fed began tightening at its March 17, 2022 meeting with a 25 basis points increase in the Fed Funds Rate and ended July 26, 2023.

Before providing observations, here are some relevant ratios that I reviewed for all U.S. banks and savings banks (not S&Ls), amounting to over 4,000 institutions, and divided them up into asset size cohorts. 

Deposit declines, much talked about in the media and banking circles, was limited to those financial institutions over $50 billion in total assets. All other asset cohorts grew deposits during the Fed's tightening.

If you look at the liquidity ratios during 4Q21, you may note that no matter the asset size, financial institutions were flush with liquidity, mostly as a result of government stimulus. If the government prints trillions of dollars, it is bound to end up in bank accounts. This is when only the most farsighted bankers were executing a funding strategy. We just didn't need the funding. Seems bizarre typing that last sentence.

The liquidity ratio calculation: (Cash & Due + Securities + Fed Funds Sold & Repos - Pledged Securities) / Total Liabilities

And look how the liquidity ratios tumbled. This data is from Call Reports. And for 1Q23, that would be period end March 31, 2023, post SVB and Signature failures. Every asset size cohort declined from 4Q22 to 1Q23, and from 1Q23 to 2Q23. Aside from the trend though, financial institutions maintained manageable liquidity ratios. The under $1B and over $50B entered the tightening cycle with 35% liquidity ratios. They ended it in the low 20's. Still strongly liquid. The challenge was that the dramatic increase in interest rates decreased the value of securities, and bankers therefore didn't want to sell them and turn a hypothetical loss into an actual one.

They were what I termed "psychologically illiquid." And today you see that playing out as fourth quarter earnings come out and many banks are taking losses in their securities portfolio to bolster liquidity and pay down high-cost borrowings.

The last increase in Fed Funds came at the beginning of the third quarter 2023 with a 25 basis points increase. During the quarter, the financial institutions over $50B experienced a 24 bps cost of funds increase. The $10B-$50B cohort experienced a 37 bps increase. I anticipate when we run this for fourth quarter all cohorts will increase in cost of funds, but at a slower pace as the gap narrows between actual Fed Funds and bank deposits. The Fed Funds is close to what a depositor could get in a money market mutual fund or short-term treasury. 

Net interest margins increased for every asset sized cohort between 4Q21 and 3Q23, except for the anomalous $1B-$5B group. This might surprise readers. But those sizable liquidity ratios in 4Q21 were as a result of ballooned investment portfolios earning under 2%. The prescient bankers had them in 1.5% short-term securities. Others reached to squeeze more margin and this move proved costly. 

The highest NIM cohort at 3Q23 was $5B-$10B who, coincidentally, had the lowest liquidity ratio at 4Q21. In other words, they didn't have to extend their investment portfolio to squeeze out 25-50 bps more because they had a relatively larger loan book. Those financial institutions cost of funds increased more than those smaller than them, but less than those larger than them. So their battle to maintain funding impacted them similarly to all others even though they were technically less liquid. 

Perhaps because they were not psychologically illiquid. 

Bankers often ask what size I think they should be to generate efficient profitability. My answer is that it is different by geography, strategy, and management teams. In the Midwest, where NIMs tend to be larger and costly infrastructures smaller, a bank can be smaller and efficiently profitable. Look at some of their profit numbers there. In the Northeast, where competition is significant and NIMs are smaller and expenses are greater, you have to be larger.

In terms of asset sizes throughout the country, you see Efficiency Ratios declining as asset sizes increase. In terms of the Expense Ratios (non-interest exp./AA), the $5B-$10B cohort is best. This may be the last sized cohort that has an over 80% reliance on net interest income for revenue. As you get larger, there are more significant fee-based contributions which typically add expense to this ratio but do not add assets, driving Expense Ratios up.   

We did measure top quartile for each of the above ratios and in terms of Expense Ratios, nearly every size category hovered at or below 2% for top quartile performers. If bankers consider their money no different than the bank down the street and can't convince customers that they should pay higher (or accept lower in terms of deposits) for service, convenience, local decision making, speed, relationships, reliability (think PPP) and deposit dollars being invested in their communities, then sub 2% Expense Ratios will likely be the new norm. And size plays an important role in driving down that number.

Size also plays a role in trading multiples, as I wrote about in 2018 (link: Jeff For Banks: The Real Reason for Bank Scale: Trading Multiples (

Back then, price-to-tangible book multiples were nearly equal for $5B-$10B banks and the largest banks. Not today. And the highest p/e multiples at this January 9th cut were in the $10B-$50B cut. Bank valuations are wonky at this writing and it is difficult to make any conclusions. But if you have enough trading volume to allow investors to get in and out without moving the market, you would be at an advantage from those that have little liquidity. Individual investors continue to yield ground to institutional investors and those funds need to be able to exit. And if sale is the only way they can exit, then consolidation is sure to pick up.

Those are my observations. I would enjoy hearing yours.

~ Jeff

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