An analyst says the US banking sector experienced a “short-term” credit crunch recently. (Reuters: Andrew Kelly)
The US Federal Reserve is injecting tens of billions of dollars into US banks on a daily basis to keep the financial system functioning smoothly.
Analysts say it follows an attempt by the US central bank to withdraw excess funding from the US economy.
Analysts warn that if US short-term borrowing costs continue to rise and money market volatility increases, major financial institutions could come under stress.abc.net.au/news/us-fed-pumps-billions-into-economy-to-avert-credit-crunch/105970180
Analysts say recent moves by the US central bank to inject cash into the system could be a “canary in the coalmine”, indicating growing financial stresses.
An extreme example of a credit crunch was the global financial crisis, which led to the collapse of US-based Lehman Brothers in September 2008.
In the days and weeks that followed, few banks would lend to one another for fear they would not get their money back.
It created a credit crunch or credit freeze, and what we now know as the Global Financial Crisis or GFC.
On October 31 this year, the Federal Reserve, equivalent to Australias Reserve Bank, injected an impressive $US50.35 billion ($77 billion) into the US financial system.
A major bank may be concerned that it does not have enough cash on hand to meet immediate requirements, like settling a transaction with another bank, for example.
It may then decide to offer the central bank, in this case the US Federal Reserve, a security, like a mortgage or bond, as collateral for an overnight loan.
The following day, the bank buys back, or repurchases, the mortgage or bond from the central bank, hence the term repo.
The Banking Landscape in 2021: Crisis Rumors vs. Reality
Let’s face it – whenever we hear news about banks and potential crises, many of us get a bit nervous. After all, our hard-earned money sits in these institutions, and the thought of any instability can trigger memories of 2008.
I’ve been researching the banking sector extensively, and there’s been quite a bit of chatter about whether banks are facing serious trouble in 2021. The answer isn’t as straightforward as some headlines might suggest.
According to the Federal Reserve’s November 2021 Supervision and Regulation Report, the banking system’s financial condition has actually improved during 2021, while some concerns persist. Let’s dive into what’s really happening.
The Good News: Banks Are Surprisingly Strong
Despite the economic turmoil caused by the COVID-19 pandemic U.S. banks have demonstrated remarkable resilience. Here’s what’s going right
Strong Capital Positions
Banks have maintained robust capital levels throughout the pandemic, and these levels have actually increased in the first half of 2021. The aggregate common equity tier 1 capital (CET1) ratio rose to nearly 13% which is higher than pre-pandemic levels.
This is significant because
- Higher capital ratios mean banks have greater ability to absorb losses
- Almost all banks are exceeding their regulatory requirements
- This provides a buffer against potential economic shocks
- It allows banks to continue supporting lending activities
Improved Liquidity
Liquidity has also strengthened considerably:
- Deposits increased by roughly $1 trillion in the first half of 2021
- Banks have invested these funds in liquid assets like cash and securities
- Liquid assets now comprise over 27% of total assets
- This is well above pre-pandemic levels
- Large banks have remained above their regulatory liquidity coverage ratio requirements
Record Profitability
Bank profitability reached impressive levels in 2021:
- Return on average assets (ROAA) and return on equity (ROE) exceeded pre-pandemic levels
- The first quarter of 2021 saw a five-year high in profitability
- Negative provision expense (banks reducing their loss reserves) boosted earnings
- Higher noninterest income from investment banking, trading, mortgage, and wealth management helped drive profits
Market Confidence
Key market indicators reflect this strength:
- Market leverage ratios improved
- Credit default swap (CDS) spreads decreased to near pre-pandemic levels
- These metrics suggest investor confidence in banks’ financial health
The Concerning Trends: What’s Worrying Analysts
Despite these strengths, some worrying signs have emerged that deserve attention:
Declining Net Interest Margins
The banking industry’s average net interest margin fell to a record low during the first half of 2021. This metric represents a bank’s yield on interest-bearing assets after netting out interest expense, and it’s a crucial driver of bank revenue.
The decline stems from:
- Persistently low interest rates
- Banks investing pandemic-related deposit inflows into lower-yielding assets
- Increased competition for loans
Weak Loan Growth
While there were early signs of a potential rebound, overall loan growth has been weak:
- Total loan balances were flat in the first quarter of 2021 and only increased slightly after that
- Consumer loans and residential real estate loans, which declined in 2020, have only recently shown modest growth
- Commercial and industrial (C&I) loans fell in the second quarter of 2021, driven by Paycheck Protection Program (PPP) loan forgiveness
Sector-Specific Concerns
Some sectors more negatively affected by the pandemic warrant closer monitoring:
- Commercial real estate (CRE) loans, particularly in retail, office, and hotel sectors
- Large banks reported net downgrades on C&I loans in entertainment and recreation
- Recovery continues to vary by location and sector
- Office sector CRE loans continued to face net downgrades even in Q2 2021
Reserves Falling to Concerning Levels
Fast-forward to the present, and we’re seeing some troubling developments. According to recent Economic Times reporting, US bank reserves have nosedived to approximately $2.8 trillion, crashing to a 4-year low. This marks the second straight week reserves have stayed below $3 trillion, a critical threshold analysts say could test the banking system’s liquidity strength.
The decline is attributed to:
- The Federal Reserve’s aggressive quantitative tightening
- The US Treasury’s heavy debt issuance pulling cash out of banks
- Money-market funds parking nearly $1 trillion daily in reverse repo facilities
Analysts at major investment banks warn that if reserves dip below $2.7 trillion, the system could face renewed volatility in overnight repo markets, potentially forcing the Fed to intervene.
What’s Driving These Trends?
Several factors are influencing the current banking landscape:
1. Pandemic Recovery Dynamics
The COVID-19 pandemic created unique economic conditions that continue to affect banks:
- Initial surge in deposits as consumers and businesses increased savings
- Weak loan demand during economic uncertainty
- Government stimulus programs altering typical banking patterns
2. Federal Reserve Policies
The Fed’s monetary policy has had significant impacts:
- Low interest rates compressing net interest margins
- Quantitative tightening draining reserves from the system
- Balance sheet reduction of more than $1.2 trillion since mid-2022 has tightened liquidity
3. Changing Consumer Behaviors
How people use banking services is evolving:
- Decreased HELOC usage as consumers prefer other lending options
- Increased competition from nonbank lenders, especially in mortgages
- Changed spending patterns affecting credit card and loan demand
Are We Heading Toward a Banking Crisis?
This is the million-dollar question. Based on the available data, a full-blown banking crisis in 2021 wasn’t imminent, but warning signs were appearing that deserve attention.
The positives:
- Banks maintained strong capital positions
- Liquidity levels were historically high
- Delinquency rates decreased across all major loan categories
- Loan modification balances declined as hardship programs wound down
- Banks passed the Fed’s stress tests in June 2021
The negatives:
- Net interest margins at record lows
- Weak loan growth limiting revenue potential
- Sector-specific concerns in commercial real estate and certain C&I segments
- Rapid decline in reserves approaching critical thresholds
- Funding costs rising as liquidity tightens
What To Watch For
If you’re concerned about banking stability, keep an eye on these indicators:
- Reserve Levels: If they continue falling below $2.7-2.8 trillion, liquidity stress may emerge
- Overnight Funding Rates: Sudden spikes could indicate funding pressures
- Credit Quality Metrics: Increases in delinquencies or charge-offs would signal deterioration
- Fed Policy Changes: Any shifts in quantitative tightening or interest rate policy
- Regional Bank Performance: Smaller institutions may show stress before larger ones
My Take on the Situation
I believe the U.S. banking system in 2021 was fundamentally sound but facing growing pressures. The strong capital positions built up since the 2008 financial crisis provided a substantial buffer against potential losses.
However, the combination of declining net interest margins, weak loan growth, and shrinking reserves created a challenging environment for banks to generate sustainable profits. The system wasn’t in immediate danger, but the cushion that once seemed abundant was fading quickly.
As someone who follows the financial sector closely, I’m particularly concerned about the rapid decline in reserves and what that might mean for market stability. If this trend continues, we could see increased volatility in funding markets reminiscent of the 2019 repo market issues.
What This Means for You
If you’re a bank customer or investor, here’s what you should consider:
For Bank Customers:
- Your deposits remain safe, especially within FDIC insurance limits
- Loan availability may tighten if conditions worsen
- Interest rates on savings likely remain low despite inflation concerns
- It’s always wise to keep some emergency funds accessible
For Investors:
- Bank stocks may face headwinds if net interest margins remain compressed
- Regional banks could experience more pressure than diversified money center banks
- Financial sector volatility might increase if liquidity conditions deteriorate further
- Watch for banks with strong fee income to offset interest margin challenges
The banking system in 2021 wasn’t in immediate trouble, but it was facing growing pressures that warranted close monitoring. The strong foundations built after the 2008 crisis provided substantial resilience, but the combination of low interest margins, weak loan growth, and declining reserves created vulnerabilities.
As we’ve seen in the years since, these early warning signs eventually manifested in more concrete challenges, with bank reserves continuing to decline to concerning levels. The financial system continues to navigate these pressures, balancing between stability and the economic realities of tighter monetary policy.
The situation reminds me of the old saying: “Banks are like umbrellas – they lend them when the sun is shining and want them back when it rains.” Let’s hope the financial system has enough umbrellas to weather any coming storms.
What do you think about the banking system’s stability? Are you concerned about these trends? I’d love to hear your thoughts in the comments below!
Signs of tighter liquidity emerging
The Federal Reserve recently engaged in what is known as “quantitative tightening” or “QT”.
It is where the central bank sells bonds and receives cash in return, or lets its bond holdings mature without buying more, thus reducing its holdings and effectively sucking money out of the economy.
However, at the same time, the US government is also selling bonds, or US Treasuries, to raise money to fund its ballooning budget deficit.
Analysts say it has put pockets of global money markets under strain and may explain why the US Federal Reserve recently announced an end to QT.
However, it has raised questions that the announcement may have been too late, with key gauges of secured borrowing having risen in the US and UK, reaching levels not seen in years.
The Reserve Bank governor tells a gathering in Sydney she is not yet concerned about the level of unemployment in Australia.
While the drivers in each case may differ, the signs of tighter liquidity are flashing across markets.
In mid-October, Mr Powell said “some signs have begun to emerge that liquidity conditions are gradually tightening, including a general firming of repo rates along with more noticeable but temporary pressures on selected dates”.
The SOFR is the Secured Overnight Financing Rate. It is essentially the interest rate on the central banks repurchase agreements.
The higher the SOFR, the greater the fear in the money markets of a credit crunch.
“That spike [in the Federal Reserve Repo facility] has gone hand in hand with a rising SOFR,” Gerard Minack of Minack Advisers told ABC News.
“So there is some tightness in funding markets,” Mr Minack said.
“My sense is that some people are now on high alert for signs of a material pick up in stress indicators.
“But most of the market remains complacent.”
Analysts say Wall Street ran out of cash on Friday night. (Reuters: Eduardo Munoz/File Photo)
US has ‘short-term’ credit crunch
On Friday, the Feds Standing Repo Facility lent that $US50.35 billion to eligible financial firms in two separate availabilities.
It was the highest-ever use of that facility since it was put in place in 2021 to provide fast loans collateralised with Treasury or mortgage bonds.
Marcus Todays senior portfolio manager, Henry Jennings, said the US banking sector experienced a “short-term” credit crunch on Friday.
“We need to keep an eye on further moves but, for now, the market is more concerned with earnings than plumbing.”
Mr Jennings said money was draining from the US financial system, prompting the Fed to step in to top it up.
Last week the RBA governor issued a blunt warning on the state of financial markets and as markets continue to shift from traditional valuation methods, plenty of cool heads are getting nervous.
Asked by ABC News about the Feds recent actions at Tuesdays press conference, RBA governor Michele Bullock responded, “I dont think there will be a credit crunch because I think thats exactly what the Fed is trying to avoid.”
“The Fed have got themselves, as I think [Federal Reserve chair] Jay [Powell] set out, to a position now where they think their reserves are about as low as they can go without introducing difficulties in the money markets for banks trying to get liquidity.
“This is obviously part of their response to that.”
However, some analysts are alarmed that the Federal Reserve has needed to step in at all.
Regional banks and credit concerns: Here’s what to know
FAQ
Which US banks are in financial trouble?
| Bank Name | City | Closing Date |
|---|---|---|
| Heartland Tri-State Bank | Elkhart | July 28, 2023 |
| First Republic Bank | San Francisco | May 1, 2023 |
| Signature Bank | New York | March 12, 2023 |
| Silicon Valley Bank | Santa Clara | March 10, 2023 |
In what year did the most banks fail?
During the Great Depression, from 1930 to 1933, approximately 9,000 banks failed, taking with them $7 billion in depositors’ assets, according to the FDIC. As a result, the Banking Act of 1933 — also known as the Glass-Steagall Act — signed by President Franklin Roosevelt, created the FDIC.
What happened financially in 2021?
While revenue increased during the COVID-19 pandemic, from approximately $3.5 trillion in 2019 to $4 trillion in 2021, increased government spending related to widespread unemployment and health care caused spikes in the deficit.
How many banks have failed since 2021?
| Years | Bank Failures | Total Assets (Millions) |
|---|---|---|
| 2022 | 0 | $0 |
| 2021 | 0 | $0 |
| 2020 | 4 | $458.0 |
| 2019 | 4 | $214.1 |