Safety & Stability: Navigating Bank Failures

Do you remember where you were when you first found out about the liquidity issues that took down Silicon Valley Bank? What was going through your mind? Was it the uncertainty about whether you could make payroll? Were you wondering if your regional bank would suffer the same fate?” Ted Dunn, Head of Coverage, Industries, and Structured Finance, Bank of the West, asked. It was a stressful time for many business owners, CFOs and corporate treasurers. Even now, making sense of the situation can be difficult.

Shortly after the Federal Reserve announced it would keep interest rates steady while leaving open the possibility for future rate hikes, and that the U.S. banking system is sound and resilient, four BMO experts—including two who recently joined us from Bank of the West—participated in a very timely panel discussion to help business owners understand the economic and financial impacts of the recent bank failures and how to prepare for what lies ahead. Our panelists included:

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  Ted Dunn, Head of Coverage, Industries, and Structured Finance, Bank of the West, Moderator

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  Scott Anderson, Chief Economist, Bank of the West

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  James Fotheringham, U.S. Financial Services Analyst, BMO Capital Markets

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  Oscar Johnson, U.S. Head of Commercial Sales for Treasury and Payment Solutions, BMO Commercial Bank

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Following is a summary of the event.

As Fotheringham noted, the liquidity crisis earlier this year amounted to the banking system’s “very own March Madness” (First Republic Bank and Signature Bank were also casualties). Since then, Fotheringham said, funding stability has returned to the U.S. banking system, though we’re hardly out of the woods. “There is no imminent sign of incremental bank runs, but we believe very strongly that banks, from a fundamental perspective, remain in a very tight spot.”

Fotheringham said there are three fundamental risks still in play: liquidity (in the near term), capital (in the medium term), and credit (in the long term).

Fotheringham said a crisis of confidence and contagion inspired the runs on several regional banks, and the risk for another liquidity crisis remains in play. “The regulatory response to that liquidity crisis was a series of one-off decisions,” he said. “There was no systemic approach to solving the bank liquidity crisis last spring.”

In the medium term, Fotheringham said banks of all sizes face the risk of higher capital requirements. “We were going there anyway. I'm sure that we'll hear about incremental stress scenarios that banks will be put to in future years due to what we learned in March. None of us saw [bank failures] coming, including the regulators, so they are anxious to change how they treat capital on certain types of securities. All of this will result in higher capital requirements for banks, not just for the smaller regional banks, but also for the very large banks.”

Longer term, banks face credit risk, particularly if the Fed goes ahead with an expected two more quarter-point rate increases later this year. “There's no hope for a rate cut later this year as there once was, and it looks like they're quite focused on curtailing inflation, which will inspire some sort of an economic cycle,” Fotheringham said. “Bank credit risk is extremely sensitive to an economic cycle.”

Anderson said the U.S. economy has so far narrowly escaped the worst of the banking stress. The economy has been resilient, largely due to strong consumer spending and a robust labor market. But he added that we’re bracing for the potential of rising credit losses and delinquencies within a slowing economy. Also, some key economic indicators, such as rising jobless claims and unemployment rates, manufacturing surveys and leading economic indicators, are all trending in a recessionary direction.

There’s also the matter of an inverted yield curve, in which short-term U.S. Treasurys have higher yields than long-term debt. Anderson noted that the yield curve has been inverted for nearly a year and appears likely to remain inverted for at least another year.

"It shows you how restrictive the bond market thinks monetary policy is today,” Anderson said. “The 3 month and 10-yr Treasury spread has been inverted now for about seven months. Historically, after between eight and 16 months of inversion in this spread, you start to get a recession. With the Fed continuing to lean toward a hawkish stance on short-term rates, I think the risk of a harder landing for the United States is certainly there.”

Johnson is in constant contact with CFOs and corporate treasurers trying to navigate this situation. He said one of the common themes that have emerged in his discussions since the banking crisis began is that companies are paying more attention to counterparty risk.

As Johnson put it, "Those who are performing the best are the ones that are most prepared.” He added that the companies staying ahead of the game are diligent with cash forecasting, actively engage with their bankers to discuss liquidity strategies, and understand the importance of payment optimization as a method to unlock working capital from their balance sheets.

"Our clients are now taking a very close look at the soundness of their banking partners and looking beyond their financials, but looking at their regulatory standing requirements, their loan-to-deposit ratios and their deposit mixes. They're thinking about the impact that it's had on them, and they also want to make sure that their banking partners are strong and financially sound.”

As Fotheringham noted, some banks are more exposed to these risks than others. Larger banks and international institutions, for example, have more reliable access to funding. They’ve also been held to higher liquidity standards than smaller banks, so any forthcoming regulatory changes will likely have a minimal impact. That’s why it’s important for CFOs and corporate treasurers to do their homework. That includes understanding whether your financial institution has a solid funding platform, high capital ratios and a diversified loan book.

“We don't know what the economic cycle is going to look like yet, but that economic cycle will have disproportionate effects on different types of assets on balance sheets,” Fotheringham said. “Concentrated exposures can get banks into trouble but having a diversified loan book is extremely helpful going into a crisis.”

None of the panelists believes we’re out of the woods yet. As Anderson put it, “The panic phase has stabilized, but the patient is still in the hospital.”

From Fotheringham’s perspective, only a systematic approach to tackling the issues that plagued the likes of Silicon Valley Bank will put an end to the situation. “The solution needs to be systemic before we can sound the all-clear signal for bank liquidity. In the near term, we're only a few headlines away from another liquidity crisis of confidence. I hope that the regulators will take a more systemic view toward a solution before we get there. The thing to look for is congressional appetite for a system-wide solution that would come in the form of a blanket guarantee on uninsured deposits. When that comes, then we can sound the all-clear signal. But the political appetite so far hasn't been there.”

In the meantime, Johnson said corporate financial leaders would do well to follow a few basic principles, including prudent cash management. "That means doing cash forecasting, looking for opportunities to maximize yield, and planning for a rainy day similar to what folks did during the pandemic,” he said. “Also, understanding the health and wealth of your bank. Interview your banking partners and look for safety and security.”

"I strongly encourage [businesses and leaders] to make sure you are clear and understand the risks of the financial institutions that you’re partnering with," suggested Dunn. "This discussion is about making sure we're prepared: we need to understand what the options are, what the issues are, what the future may look like, and how to prepare for it."