- Milad Taghehchian, CPA, CFP(R)
What's up with the banks?
Concerns about the banking sector have been in the headlines for the last few weeks. Why did we see a few banks fail, and what does it mean going forward? Separately, we have seen a lot of cash come out of bank accounts over the last few weeks. Why is that, and what impact can that have on the health of the financial sector? Let's go into it.
Why do we need banks?
Banks are a vital component of our financial system. The importance doesn't stem from the obvious, a place to hold our cash. The real impact is the lending capacity of both large and regional banks.
Here is the fundamental reality of our economic system. Someone has a really cool idea, but they have little cash, access to investors, or friends and family with cash. In order to make their idea possible, they usually have to borrow some money. It's hard to make a really amazing idea happen without a good amount of up-front capital. So the person with the great idea usually ends up in front of a banker to get the capital needed to fund their idea.
Banks have a certain capacity for risk in different loan products. For example, a bank in rural Texas may be a huge fan of loaning money to folks who want to purchase farm equipment. Agriculture is something that the borrower and lender each know all about. The business risk is well understood. Likewise, a bank in San Francisco may have an appetite for risk that is a bit different. They may better understand the start-up tech world and target their business toward venture-backed companies.
Over the last decade, the bank's lending process has remained consistent. A regional bank can get money from various federal loan programs as long as the bank's capital supports the debt service on the loan. Banks borrow at whatever rate they are offered by these various programs. Over the last decade, borrowing cost the banks around 0-2%. The banks then take the money they borrowed and loan it to their customers. The bank in rural Texas may loan money to a farmer or rancher and charge 5%, netting the bank around 3%.
In order to be able to take loans from the federal government, banks have to maintain some level of capital and assets. A long time ago this was gold. Decades ago it was cash-on-hand. Now it is a more convoluted series of assets or derivatives of assets. The moral of the story is the same. Banks have to have some assets with predictable value to support loans from the federal government.
Without this system, cool ideas don't get funded. Cool ideas are what turn into cool businesses that then people around the world want to use or purchase. If we don't have a steady flow of money going to cool ideas, the economy doesn't perform as well. We need people consistently creating neat things that other people want to buy.
So what happened in March 2023?
"Only when the tide goes out do you learn who has been swimming naked." - Warren Buffett
The tide came in. Since 2008 the Federal Reserve, other central banks around the world, and most governments have been creating a lot of very cheap money. More money is being created, and interest rates have been very low. The rising tide lifted most boats. When there is so much cheap money around the price of everything increases. That doesn't mean the value of everything increases, but the price sure does. The value of a loaf of bread is still the same as it was 20 years ago, but the price of that loaf of bread has increased significantly due to the quantity of money.
When the money supply is so high at such low costs, people with cool ideas are more encouraged. The crazier cool ideas that wouldn't have held muster now seem like low-risk bets when money is so easy to get at such a low cost. Why not do the crazy idea? However, when the cost of money (i.e. interest rate) increases, everyone has to be a lot more careful. This started happening in late 2021 and hit a wall in March 2023.
Silicon Valley Bank had a natural customer base that included a lot of risky tech-heavy companies with cool/crazy ideas. As other banks did, SVB provided these companies with loans at low rates. When the market turned sour and the cost of money increased, many of those companies began failing. As a result, Silicon Valley Bank needed to shore up its asset base. They were caught without a solid asset base at the exact moment they needed it. The tide went out.
What about all the flows of cash out of bank accounts?
This is a less interesting and easily explained phenomenon. Banks nationwide did not increase the rate they were paying on savings accounts and CDs as quickly as money market accounts and short-term bonds did. People were then incentivized to pull money out of savings accounts at low interest rates to invest in products that pay higher interest.
But what happens when this money moves around? Some of these funds went to other banks. This keeps the flow of money in the banking system about the same as before. The banks that received the funds will just have more lending capacity than the ones that lost deposits.
A lot of these funds didnt go to banks, but instead money market accounts managed by investment companies. Money market funds often provide very short-term loans to large corporations or the federal government itself. This reduces how much funding can go to smaller businesses or individuals with cool ideas. This can create a diversion of growth between bigger businesses and smaller ones. Over longer periods of time, it is preferable to have more funding distributed to smaller businesses as that is the true engine of economic innovation and growth.
So is the world collapsing, and are we heading toward a financial apocalypse?
The universe is expanding and eventually, our sun will burn out. We are definitely headed toward an apocalypse sometime in the next 100 billion years. However, this kind of banking fluctuation, transition, and movement is perfectly normal. It is a standard part of economic and business cycles. It does present some opportunities and challenges over the next 6-24 months.
The biggest challenge/opportunity is that smaller borrowers may have a tougher time getting standard loans. Usually, this gap in funding is filled by other forms of lending from non-traditional lenders. Often, we find this to be a time when investors with access to capital can take the place of standard lenders. The balance between traditional lending and investing is still yet to be determined, but there are definite opportunities on the horizon for investors.