April 27, 2023
In the simplest terms a balance sheet compares how much stuff you own versus how much stuff you owe. The excess of what you own compared to the stuff you owe is equity – i.e. your net worth. If you were to prepare your personal balance sheet (not a terrible idea to do occasionally), you would itemize the cash in your bank account as an asset and your mortgage as a liability. Your bank thinks of it in the opposite terms. Your checking account is a liability to them, and your loan is an asset. The chart below of a bank’s balance sheet is simplified to further the conversation below.
Deposits are typically steady, but that only holds true if depositors believe that they can safely store their money at the bank for when they need it. When confidence is shaken, banks see higher than predicted outflows. During extreme events the bank will not have enough cash on hand to fund such withdrawals, but such an occurrence can normally be handled by selling securities. Loans are not as easy to sell quickly.
The problem today is that the securities banks own have lost market value from where they bought them as interest rates have increased. If they were to sell them, they would recognize a loss even though these assets are generally high-quality government bonds that should mature at par. This part of the story was poor assetliability and liquidity management by the bankers, not 2008 all over again.
Historically, though, it has been loans that are at the epicenter of banking crises. Banks are in the business of lending money to people and companies. During good economic times, most of these loans are repaid or refinanced, but when economic conditions deteriorate, some of these loans are at risk of default. Banks put money aside as loan loss reserves to cover these potential shortfalls. For global financial institutions, loans are varied by size, borrower, industry, etc.; however, for many community and regional banks, loans are geographically concentrated, and many are tied to real estate – commercial and residential. One of the concerns in the market now is that many of those loans were made at low interest rates and near peak real estate market pricing. What happens if borrowers start defaulting at a higher-than-expected rate due to a potential economic downturn? If the write-offs are above loan loss reserves, equity is used as the next buffer.
A potential run on the banking sector was wiped from the news headlines in about a week’s time which is amazing. The surest recession in recent memory keeps getting pushed further into the future. Employment remains strong. Interest rates have stabilized, and inflation is coming down. Banks seem to have time to revisit their balance sheets and address any potential deficiencies. Over the coming quarters, we will see whether that is being done and if we can put this problem behind us.
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