Banks faced a turbulent year in 2023. Over a five-day period in March, three small to mid-sized banks failed, including Silicon Valley Bank (a subsidiary of SVB Financial), the largest bank failure since the Great Recession nearly 15 years ago.
The failures happened early this year and revealed how poorly prepared some banks were for today's high-interest rate environment. As we approach the end of the year, let's look back at some of the trends that upended the industry and weighed on many other stocks during the year and how the industry moves forward from here.
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1. High interest rates hurt ill-prepared banks
In the years following the Great Recession, banks grew accustomed to a low-interest-rate environment. Lower interest rates can impact banks because they collect less net interest income, or the difference between the interest paid on deposits and interest earned on loans. Higher rates can benefit banks because they help widen the net interest spread, which we saw last year as banks posted stellar net interest income growth.
However, some banks were ill-prepared for interest rates to go as high as they did, including Silicon Valley Bank. The start-up-focused bank invested heavily in mortgage-backed securities and other bonds during the low-yielding environment during the pandemic.
Usually, this wouldn't be a problem if it could hold the loans to maturity. However, it became a problem when its clientele, many start-ups and venture capital funds, saw funding dry up amid higher interest rates. Also, most of Silicon Valley Bank's deposits were non-interest-bearing and above the Federal Deposit Insurance Corporation's $250,000 limit.
Clients began to pull money from the bank, triggering a nightmare scenario where Silicon Valley Bank needed to raise funds by selling underwater bonds or issuing stock, which the market didn't take too kindly to. We all know what happened next: Regulators seized the bank, and the Federal Reserve introduced the Bank Term Funding Program to help other banks that needed funding to prevent runs at other banks.
2. Banks that rely on low-cost deposits have come under pressure
Generally, higher interest rates can benefit banks because they tend to cause net interest margins to expand. However, interest rates have risen rapidly since March 2022 as the Federal Reserve raised its benchmark interest rate from near zero to 5.25%.
As a result, banks that rely on low-cost deposits saw those deposits outflow as customers moved their cash to higher-interest-earning assets, such as high-yield savings accounts or certificates of deposit.
One bank feeling the heat was Charles Schwab. From the start of 2022 through May of this year, Schwab saw its average bank account deposit balances fall by nearly $55 billion or 35%. Outflows at Schwab have slowed in recent months, but investors will still want to keep a close eye on deposit flows, especially if interest rates remain elevated.
US Banks Noninterest-bearing Deposits data by YCharts.
Declining deposits continue to impact banks like KeyCorp and Comerica, whose stocks were downgraded in August by the credit rating agency S&P Global.
Thus far, these banks have held up better than Silicon Valley Bank because their customer bases aren't as vulnerable. Still, banks will continue to face pressure and may have to raise interest rates on deposits to keep customers happy -- which will continue to put pressure on net interest margins.
3. Lending has tightened significantly, hitting specific industries and consumers hard
The bank failures in the early half of the year were a warning to banks to get their financial houses in order. The Fed's Bank Term Funding Program helps banks shore up liquidity, but they shouldn't expect this program to be around forever.
In improving their balance sheets, banks have pulled back significantly from lending, especially to areas of the economy deemed higher risk. According to the Federal Reserve's October 2023 Senior Loan Officer Opinion Survey on Bank Lending Practices, a significant amount of banks reported tightening lending standards on credit cards and other consumer loans. During this period, banks required higher income and were less likely to approve loan applications for those with lower credit scores.
Banks also tightened lending standards for commercial and industrial (C&I) loans to firms of all sizes in the quarter. Reduced lending to these firms means less capital for firms to hire and expand and also tends to mean that a recession isn't far off.
Looking toward 2024
Banks have had a tough go of it this year. Since the start of the year, the SPDR S&P Bank ETF (KBE -0.31%) has fallen nearly 5%, while the SPDR S&P Regional Banking ETF (KRE -0.58%) has lost almost 17%. The struggle in banks brings to mind the classic quote from Berkshire Hathaway CEO Warren Buffett: "Only when the tide goes out do you discover who's been swimming naked."
Banks will continue to face headwinds from the higher-interest-rate environment, although they may get some relief if the Federal Reserve cuts interest rates next year. According to CME Group's FedWatch Tool, the market is pricing in five interest rate cuts by the end of next year.
However, today, banks continue to deal with high interest rates and tightening lending conditions, potentially leading to a recession in 2024. If that were to happen, investors should stand ready to put cash to work in high-quality bank stocks next year if they are to take a further dip from here.
