Midsize banks face new funding risks after debt deal

William Perry/Bill Perry - stock.adobe.com

The end of the battle over the U.S. debt ceiling has brought calm to the financial sector, but some banks may not be out of the woods just yet.

Large regional banks, some of which are still reeling from a crisis of depositor confidence this spring, could be stressed further by having to once again compete with the federal government for funding. As the Treasury Department tries to refill its coffers after emptying them during the protracted debt fight, it'll issue short-term government debt that might be a more attractive option for investors than potentially unsteady bank deposits. 

Just ahead of Treasury's "x-date," the point at which the government would run out of money to pay its bills, Congress passed a spending agreement, which President Joe Biden quickly signed. A default would have been catastrophic, but the 11th hour reprieve will still have consequences for the financial system. 

During the recent banking crisis, banks have had a major advantage: They haven't had to compete in a meaningful way with essentially riskless government bonds. As deposits fled from large regionals in the early days of the turmoil, they mostly fled to banks considered "too big to fail." 

"Not only are they competing with the most attractive asset in the world, but with an increased supply of that asset," said John Rizzo, a senior vice president at the Clyde Group and a former Treasury official. "So that's going to be a challenge if you're a midsized institution and you had any type of deposit flight over the last six months. Part of that risk you experienced was ameliorated by the normal amount of Treasuries or securities in the market kicking around." 

Now that the Treasury can issue new debt, that competition is about to heat up, and the money could leave the banking system entirely. 

"So do those institutions experience deposit flight again, or is deposit flight done?" he said. "We just don't know the answer to that." 

Since the U.S. hit the debt ceiling in mid-January, the Treasury Department has been unable to issue new debt. Because of this, the agency's general account at the Federal Reserve has dwindled to less than $50 billion. In the coming months, it is expected to replenish its cash holdings to the tune of $600 billion or more by selling short-term securities known as Treasury bills, or T-bills.

This is a minor problem for most banks — albeit a substantially smaller one than a debt default would have been — but a particularly tough scenario for large regional banks already teetering from this year's turmoil in the industry after the failure of Silicon Valley Bank. Those banks have already had to pay higher interest rates to retain deposits.

"We could see a slight amplification or continuation of the recent story that we've been seeing in terms of the cost of funding for banks," said Michael Redmond, an economist with Medley Advisors who previously worked at Federal Reserve Bank of Kansas City and the Treasury.

Redmond added that rising funding costs combined with low-yielding loans and securities holdings means smaller net interest rate margins for banks, therefore placing downward pressure on profitability.

"Paying for funding in the current market environments, especially when some of their assets are locked in at low interest rates for long periods of time — that's not looking good for earnings and cash flow for investors," he said. "That's why you're seeing the regional bank stocks and the like remain pretty low in terms of where they're trading."

Politics and policy

With a debt deal pending, changes are coming to the Fed's balance sheet

May 30, 2023 9:00 PM

Mayra Rodriguez Valladares, managing principal of the consultancy MRV Associates, said the banks most threatened by a renewed competition in the funding market are those that have remained reliant on large corporate customers whose deposits exceed the federal deposit insurance limit of $250,000.

"The banks that would be at risk would be banks that have what we call very lumpy deposits," said Rodriguez Valladares. "In other words, if you still have regional banks out there that haven't learned their lesson not to rely too much on huge uninsured deposits, those are the ones that are more vulnerable to some corporate treasurer asking 'Why am I still here?'"

That's the reason why the Treasury Department prefers to issue debt in a reliable, predictable way, allowing markets to have time to adjust. In a long debt ceiling debate, that's not always possible. 

"In their ideal world, what you want to do is have a very long dialogue with the market so the market can see clearly how much, what offerings the Treasury will need to issue, which ones they're likely to issue, and over time when those auctions will take place," Rizzo said. "Now they've got to do a really quick scramble to issue securities, have the auctions, to get straight on the debt ceiling." 

Another question for banks is what the replenishment of the Treasury General Account will mean for the Fed's balance sheet. As Treasury's funds increase, other liabilities on the Fed's balance sheet will have to shrink commensurately. 

The two largest liability categories on the Fed's balance sheet are the Overnight Reverse Repurchase Agreement, or ON RRP, facility — through which money market funds buy securities from the central bank and agree to sell them back at a higher price — and reserves, which serve as cash for banks to settle payments with one another and offset losses.

If the uptick in Treasury issuance is absorbed by bank depositors, it could cause the supply of reserves to fall. When reserves become scarce, volatility often ensues. 

But analysts expect money market funds will take on the bulk of the new issuance, resulting in a shrinking of the ON RRP facility, which has been used at historically high rates since last year. The Fed's Federal Open Market Committee, during its meeting last month, attributed this elevated use to a "limited supply of alternative investments such as Treasury bills," according to meeting minutes.

Rodriguez Valladares said the relatively low-yields offered by T-bills are unlikely to draw many customers away from banks, noting that more lucrative alternatives have been available throughout the entire period of volatility.

"On balance, there could be a little bit of a headwind, but I'm not expecting a huge rush of people pulling deposits from regional banks to go buy new treasuries," said Rodriguez Valladares. "People have had that opportunity. Since 2022, they've been seeing rates rise. They could have been buying Treasuries already, going into money market instruments or into bonds. I don't see this as such a new thing that only now can they go buy Treasuries, but you will have some who will do that."