Interest Rates, Regional Banks, and the Debt Ceiling

Interest Rates

In the past two months, we’ve had multiple regional banks fail, and at the same time, the Federal Reserve Bank keeps raising interest rates. How are the two things related, and why are the regional banks affected more than the larger banks?

The Federal Reserve just raised interest rates for the tenth time in a row since March 2022; however, they also signaled that this was probably the last increase for a while. Interest rate hikes take time to work through the economy, and now, almost a year later, we’re seeing some goods and service prices drop, or at least not increase as much. The Fed wants to wait a while and see if inflation goes down as economic conditions tighten. What happens after rate increases stop? As the chart below shows, the Russell 1000 (larger US stocks) has shown very positive returns six months following peak rates.

Source: Bloomberg, March 2023

Regional Banks

We’ve had two large regional banks fail in the past few months: Silicon Valley Bank (purchased by First Citizens Bank) and First Republic (purchased by JP Morgan Chase). Why? Both banks had slightly different reasons—SVB failed due to its poor risk management, and First Republic failed due to its large uninsured deposits, which caused a bank run. A bank run is when depositors demand their money and move it to another institution. Well, banks keep 10% or less of their deposits on hand for redemption, as the balance is either invested or loaned, which is how they make money. We talked about Silicon Valley Bank in a previous article (https://bluerockwealth.com/blogs/perspectives/silicon-valley-bank-svb ).

First Republic had a large number of loans at very low interest rates as well as uninsured deposits (deposits over the $250,000 FDIC limit), as their customer base was extremely affluent. As the Fed increased interest rates, the value of those loans declined, which caused investor concern about the capital base. At the same time, because a large number of accounts at the bank were over the FDIC protection limits, depositors started to withdraw funds, which caused the bank to fail. It wasn’t a case of the bank making bad loans; they didn’t. The bank’s interest rates on the loans were below what the current interest rates are. As long as the borrowers paid those loans back—and there was no indication they wouldn’t—the loans were fine, but the increase in rates temporarily eroded their value. This scenario also occurred because the bank invested excess deposits in bonds. Those bonds dipped in value, although the bonds themselves were fine and were likely to pay back the principal value at maturity.

In both banks’ cases, a classic bank run coupled with higher interest rates caused their demise. Both banks’ purchasers got an amazing deal, with the FDIC backstopping loan losses and other downsides, but depositors were made whole, and the banking system remains sound. This sort of deal-making is likely to continue as other regional banks potentially fail.

So why are regional banks affected and not big banks? This question will be studied for many years to come, but a few primary reasons stand out. For example, the regional banks tend to have less diversified depositors and loans. In the case of both banks, they had very wealthy customers or large corporate customers that had accounts well over the FDIC limits. Additionally, both had a concentration of loans either geographically or within a certain economic segment (high net worth clients). The larger banks are much more diversified, meaning they have customers in all corners of the country and fewer uninsured deposits, and they give loans to a more varied sample of industries and individuals. Various government agencies also regulate the large banks to a greater degree.

Depositor sentiment also plays a key role in the large versus regional banks. For instance, in 2008, during the height of the financial crisis, a doctrine of “too big to fail” surfaced. In essence, some banks are so large that their failure would be detrimental to the economy. Effectively, regulators will always bail out these banks, so depositors (even uninsured depositors) feel protected. Yes, this does cause an uneven competitive environment for the two classes of banks, but the larger banks also get more scrutiny, and have more stringent requirements. Basically, this scenario is simply a perfect example of how life isn’t fair!

The Debt Ceiling

Of course, the debt ceiling debate is another issue for the markets to worry about. In essence, the debt ceiling is simply like a credit card limit. However, unlike a credit card limit, Congress can simply increase it. No matter which party is in power, the opposing party will make a big deal about the debt ceiling and blame the other party for reckless spending, tax cuts, etc. However, in the end, a deal is made and the ceiling is raised. The political rhetoric is painful to watch and hear, but neither party wants to be blamed for a default, so the likely solution will be a debt ceiling suspension past the next Presidential election. Then, in late 2024 or early 2025, we’ll feel like we’re in the movie Groundhog Day as we listen to the same debate. The ceiling has been raised over 60 times in history; this time is not likely to be different.

What does all this mean to us? Well, we may sound like a broken record, but diversification is the key. Avoiding concentrated positions (individual stocks) and also limiting any one industry to a small percentage is still the flavor of the day! Our portfolios are designed to withstand this sort of volatility, and like all volatility in the markets, this is all simply noise to ignore.

Remember, the only bad question is the one you don’t ask, so feel free to reach out to your Bluerock Team with questions.