Branching Out: Challenges for Banks Present Opportunities for Investors

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Stacie Jacobsen: Thanks for joining us today on The Pulse by Bernstein, where we bring you insights on the economy, global markets, and all the complexities of wealth management. I'm your host, Stacie Jacobsen. Today, we're talking about the banking sector. The rapidly rising interest rates of the recent past and the prospect of stricter regulations have changed the banking landscape.

In response, banks are reevaluating their business models, and some are shifting away from traditional lending. This realignment has opened up significant opportunities in private credit investing. So, joining us to explore these developments in the banking sector is Ben Goetsch, senior investment strategist at Bernstein.

Ben, thanks so much for being here today.

Ben Goetsch: Thank you, Stacie. It's great to be here.

Stacie Jacobsen: You're here to talk to us about the banking sector and how I'd like to structure our discussion today is to start with, how did we get here? And then we'll go into what are some of the opportunities, what are the things to look out for, and then where do we go from here?

Let's go ahead and get started with that first part. What's going on in the banking industry and how did we get here?

Ben Goetsch: Yeah, Stacie. I think it makes sense to start at the basic level. What does a bank do at its core? A bank borrows in the very short term. So think your checking account, your savings account, and it lends in the long term.

So, think your 30-year mortgage, or maybe it buys a 10-year treasury bond. And so, the benefit to a bank is when short term interest rates are lower. And it can lend at a longer term, higher interest rate. It makes that spread. So that's the business model of a bank in principle, when you have a period like the last couple of years where interest rates went from zero for not just the last two years, but most of the last 15 years to above 5%, where we are today.

That causes an issue for banks that have those long-term loans outstanding. So, think your mortgage that you might have gotten in late 2020, early 2021 at 2, 3%. But they're paying potentially depositors over 4%, so that is a drag. And when you think about what that means for savers, you know, I might be getting 0 percent of my checking account today and I can look over at a T-bill and get 5%, I'm probably going to take my money out of the bank unless I need it and go buy T-bills.

So, what we saw over the past couple of years is deposit flight from banks. So. Depositors pulling money to buy treasury bills to buy money, market funds to buy stocks and bonds, and that caused an issue at the banks. And meanwhile, for banks that had taken those deposits and lent them over the longer term, either by lending over 30 years on a mortgage or buying a 10-year treasury bond, they were in a tough spot because those.

Securities and those loans were suddenly worth quite a bit less. So, it made it difficult for those banks to suddenly sell those securities and loans to fund these deposit outflows. And that is principally what we saw happen at banks like Silicon Valley bank, where they saw a huge amount of deposit outflows in a very short period of time and had significant losses on their balance sheet from securities they had purchased that were longer dated.

And that caused them ultimately not to be able to meet those deposit outflows.

Stacie Jacobsen: So that leads me to the question, are all banks impacted equally by the interest rate spread?

Ben Goetsch: It impacts banks differently depending on how they grew their assets over time and how they invested those assets. For example, if you were a bank like Silicon Valley Bank, they've got enormous deposit inflows in 2020 and 2021 very tied to the tech sector.

You might remember that venture capital was a hot space in 2020 and 2021. A lot of cash going into venture capital firms, which was then deposited at Silicon Valley bank. They had to do something with that money and they put it into longer dated securities; usually very high credit quality securities like treasuries, but securities, nonetheless.

And so, anyone that got very significant deposit inflows and then put that cash to work in longer dated mortgages, longer dated securities, is now experiencing this friction. There are some banks, frankly, that didn't see nearly the degree of deposit outflows, and there are also some banks that didn't have the same level of exposure to longer term interest rates.

And so, it really depends on the circumstances of the particular institution.

Stacie Jacobsen: So, Ben, the regulatory environment is shifting as well. Can you talk us through the shift?

Ben Goetsch: Yeah, the immediate problem for banks and for many banks is the interest rate issue that I just described, and that's being dealt with in a couple of ways.

One is, uh, the emergency facilities put in place by the Fed and by other regulators to stem those deposit outflows or finance those deposit outflows through short term financing. Those will help those banks get through the near term without any sort of big crisis, and then subsequently, those security losses are unrealized.

And eventually, those securities like Treasury bonds, like mortgages are likely to pay off. And so, you'll see those losses diminish over time. But what happens after that? What happens in the future? Well, In the course of the post financial crisis regulations, the Fed and other regulators are set to introduce a new set of banking regulations known in the U.S. as Basel III, in Europe as Basel IV, and those regulations are likely to have the effect of causing banks to increase the amount of capital they have to hold against certain types of loans and securities.

And what that means is if you're a bank today and you are meeting your capital requirements, uh, just barely, and these regulations come into force, you have to find potentially as much as 10 to 20 percent more equity to hold against your assets.

In the future, and that creates a challenge for banks because they need to find the cash somewhere and they need to potentially even change their business models to deal with this.

Stacie Jacobsen: And is that impacting all banks the same or does it matter what their assets are?

Ben Goetsch: Actually, this is an area that impacts the largest banks most prominently.

The smallest banks are typically exempt from these regulations. So, think your community banks, your banks that are under 10 billion. The threshold for these regulations is actually a hundred billion in assets. So large regional banks will be significantly impacted by this. And even the globally systemic financial institutions, the largest banks will also be affected.

Stacie Jacobsen: Ben, so given that as a backdrop, what are some of the opportunities for investors and then maybe also those things that we should be looking out for?

Ben Goetsch: Sure. If you think about what has happened in the banking sector, there are going to be, and frankly have already been a few actions that banks need to take to deal with these problems.

And one is, frankly, they have to lend less. So, if you think about a bank that has seen deposit outflows, that has, uh, unrealized loss. It's on its balance sheet. One of the first steps that bank can take is just to pull back on its lending to increase its credit criteria. And that provides a credit vacuum that can be filled by private lenders.

So private credit is an area that has grown substantially since the 2008 financial crisis, largely as a result of those post crisis financial reforms that have put more restrictions on banks. These are likely to do the same and frankly, enhance the opportunity set for private lenders to step in and take the place of traditional lenders like banks.

Second, banks are going to need to optimize their balance sheets. It means they have to raise liquidity to meet these deposit outflows. They have to raise capital to meet new capital requirements, and that is resulting in a number of opportunities to buy assets from banks to provide solutions to meet the new capital requirements and to meet their liquidity needs so that those assets can often be liquidity needs. so that those assets can often be purchased at discounts to achieve attractive return profiles in the future.

And then finally, if we look forward, banks are now in a position where they're going to have to hold more capital against their assets. They have less capital to lend in the first place, but those banks still need to run a business and they still want to keep their customers.

So, one area of opportunity that we're starting to see is direct origination of loans through banks. So, if you think about a bank that does not necessarily have the balance sheet to lend, but has a number of clients that it wants to keep for various reasons, maybe to earn fees, maybe to have business in other parts of the bank, they can engage a private lender to provide that capital, to make new loans, which we would call a forward flow arrangement.

And this provides an ongoing opportunity beyond the balance sheet optimization that we're seeing right now.

Stacie Jacobsen: All right, I have a question on the opportunity and how long it may last. I've read that there's significant funds in the billions of dollars being raised to fill that vacuum for loans. Is this something that you think will continue to persist, or is the opportunity being diluted by the amount of funds being raised?

Ben Goetsch: Yeah, I mentioned before that the private credit industry has really grown substantially since the 2008 financial crisis, and you're right, you've seen funds raised over the past couple of years, in some cases in the 10 and 20 billion dollar range, but if you think about the private credit world in the context of the global financial system, the IMF estimates that the private credit is now totaling around $2.1 trillion of assets, which sounds like a very big number, but if you compare that to the global banking system in the US alone, banks have around $24 trillion of assets.

So, it's still a relatively small amount in that context. And then if you think about the fact that much of the private lending so far has been concentrated in a few areas that were particularly impacted by the post financial crisis reforms in 2008, there are other areas of the lending markets that private lenders have not touched nearly as significantly.

So, there is a significant amount of opportunity to come for private lenders to fill that gap.

Stacie Jacobsen: You had mentioned that the banks need to optimize their balance sheets. So, they're willing to sell some of their assets. Are they picking and choosing? Are these riskier assets that they're selling? So how should investors be wary of what they're buying from banks?

Ben Goetsch: This is where experience really comes in because banks have a number of different ways to lend to a number of different clients and customers. And so, expertise in different types of loans and loan portfolios is critical when underwriting these types of transactions, the worst thing you can do is jump into this type of market without an understanding of how to look at what could be a pool of say 10,000 individual loans.

So, the first thing I would say is a significant amount of experience and expertise is warranted in this type of space. Banks are looking across their balance sheet and trying to find the areas that are most profitable for them to keep and least profitable for them to sell. In some cases, the riskier assets are the least profitable assets as well.

So, they might be the first to go, if you will. So again, there's this effort to try to find the balance between getting a very high return, but also looking at the potential risks in any pool of assets and trying to balance the two.

Stacie Jacobsen: Okay, so then let's talk about banks themselves. Are bank stocks a good buy right now?

Ben Goetsch: Well, this is where it's really critical to understand that not all banks are impacted equally by these developments in the industry. So, first of all, in the case of the interest rate shock that we saw over the last couple of years, again, the most heavily impacted banks were those that grew assets.

Quite significantly, usually in the form of deposit inflows over the course of the prior few years, because those were the banks that had to put those assets to work in long dated, low yielding assets. If you look at the banking system today, those banks tended to be the middle to large size regional banks.

And that's frankly where Silicon Valley Bank fit in prior to its failure in 2023, the larger banks got deposit inflows during that period because they were deemed to be safer. And frankly, the smallest banks, if you think about micro-cap community banks that are very locally oriented, they're very small in terms of their market footprint.

They're actually doing quite well because they've had to keep their client base as a result of those clients getting preferential service that they're not going to get at larger institutions. So, what you can see today is the profitability of the banking sector is really bifurcated by banks that were really hampered by deposit outflows and the losses on their balance sheet, which tend to be in the middle, and then the smallest and largest banks, which have tended to fare reasonably well, even through this circumstance.

Stacie Jacobsen: Let's get into the where do we go from here part of the conversation, and we'll start with lending. Is this a permanent shift for banks away from lending at the scale that they once did?

Ben Goetsch: It remains to be seen. I will say that certain areas of the credit markets might be places that banks have to stay away from for the foreseeable future, just because of the regulatory burden of lending in those areas.

We've seen that in areas of the lending markets since the global financial crisis, where private capital really has become a significant player while banks have pulled back quite substantially. We could see that continue in other parts of the credit markets as well. It will depend in part on the regulatory burden that is put on these banks as these regulations are finalized and it will depend on the ability of those banks to adapt their business models.

But I do see significant shifts continuing into private lending as a result of both the interest rate shock that we've seen and the ongoing regulatory burden that's likely to come as Basel III and Basel IV take place.

Stacie Jacobsen: We haven't had the chance to talk yet about real estate debt. How is the loan environment in the banking industry impacting the real estate market?

Ben Goetsch: The real estate market is something that's been a topic of interest for the last couple of years, in part because we've seen significant movement of people, right? You have people not moving into big cities as much. Offices are a bit more vacant than they were prior to the pandemic. So, there are fundamental issues that we're seeing, but also just the interest rate environment as well.

And Commercial properties are generally levered properties where they take out a commercial mortgage to get some income from rents and as interest rates rose, they now have to pay a significant amount more of interest on those mortgages. So, what we're likely to see over the next couple of years is a significant amount of stress in the commercial property market related to refinancing of that debt.

So, taking a two, three, four percent mortgage and turning it into an eight, nine percent mortgage where you're not even allowed to take on as much leverage as you were before. What is noteworthy is that regional banks were a significant lender to the commercial property market, and we've seen this crop up in a couple of bank issues even this year, where significant losses as a result of commercial property loans have hampered the ability of some regional banks to earn profits.

This is a stress point that private lenders again can take advantage of. So, if you are a lender to commercial properties and suddenly banks are no longer there to step in to either refinance debt or to provide new loans, private lenders can fill that void and earn substantially more than prior to this development.

Stacie Jacobsen: I do want to ask about the interest rate environment because coming into 2024, the consensus expectation was that the Fed would cut maybe three or four times by the end of this and now that expectation is maybe one. How has that adjustment impacted the banking sector?

Ben Goetsch: We discussed earlier how some of the issues that the banks are facing stem from the increases in interest rates over the past couple of years, both on the deposit funding side.

So, you've seen deposit outflows to get higher yields from things like money market funds, and also on the asset side, where you've seen securities portfolios and mortgages at banks become less valuable. Both of those have been headwinds, and you could imagine that both of those could be helped by interest rates coming back down.

And so that is something that banks have been looking at. It's not necessarily a cure all, but if the fed were to come in and cut rates, that could help both of those issues. So, the Fed now potentially on hold for some time to come potentially until close to the end of the year, it remains to be seen.

That is just another stress point on these banks that face these significant issues, because that means deposits continue to face more competition from other short-term vehicles, like fee bills and money markets that are yielding significant amounts and their securities portfolios have not had the pace of recovery that they might have had interest rates come down faster.

So, we expect that those stresses will continue to impact profitability and continue to impact the decision making at banks.

Stacie Jacobsen: Ben, do you have any final thoughts that you'd like to leave us with?

Ben Goetsch: It's an interesting time in the banking sector where you start to see interest rates rising for the first time in really over a decade.

And these stresses can cause some consternation, some fear on the part of folks who lived through things like the great financial crisis. It seems like we've gotten past this without a significant banking crisis and without significant knock on effects on the economy, which remains quite strong, but it still does bring about significant opportunities, particularly for private lenders who are able to step in as banks pull back and provide solutions to the very same banks by buying assets or working on other solutions to help them deal with these interest rates and, uh, regulatory issues that they're facing.

Stacie Jacobsen: All right. Well, disruption does cause uncertainty. I do want to thank you for highlighting the opportunities as well today. So, thank you for being with us.

Ben Goetsch: Thank you, Stacie.

Stacie Jacobsen: Thanks to everyone for listening. If you'd like to do a deeper dive into the topics we discussed today, I'd like to recommend starting with the recent blog that Ben wrote.

We will certainly link that in the show notes, or you can look it up at Bernstein. com. Please tune in for our next episode in two weeks from now. So, in the meantime, don't forget to like share and subscribe to the pulse by Bernstein, wherever you get your podcast. I'm your host, Stacie Jacobsen, wishing you a great rest of the week.