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.
All banks hold some cash in case someone takes a withdrawal, but if they did nothing other than hold deposits as cash in their vault, they would never make money. In normal times, the managers of the bank can estimate how much cash they need to have on hand to fund withdrawals. Anything above that level they use to underwrite loans or buy securities which produce income for them. The difference between what they earn from lending and owning assets and what they need to pay to attract deposits is profit. Again, this is an abridged version as most banks have other forms of earnings and costs.
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.
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.
Kevin is Cornerstone’s Chief Investment Officer and is involved with the firm’s Investment Policy and Strategic Planning committees. Kevin joined the company in 2000 after graduating from Lehigh University with a B.S. and M.S. in Economics and earned his CFA charter in 2005. Kevin supports many charitable causes and has established a donor advised fund to propagate his philanthropic interests. Kevin lives in Bethlehem with his cats Zola and Charlyne, enjoys woodworking, gardening, reading and travel. Kevin is the proud uncle to many nieces and nephews and loves spending time with and spoiling them.
Disclaimer Notice
This material is prepared by Cornerstone Advisors Asset Management, LLC (“Cornerstone”) and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the published date indicated on the article and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Cornerstone to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Cornerstone, its officers, employees or agents. This material may contain ‘forward looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
Any accounting or tax advice contained in this communication is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
The information is provided solely for informational purposes and therefore should not be considered an offer to buy or sell a security. Except as otherwise required by law, Cornerstone shall not be responsible for any trading decisions or damages or other losses resulting from this information, data, analyses or opinions or their use. Please read any prospectus carefully before investing.
This material is prepared by Cornerstone Advisors Asset Management, LLC (“Cornerstone”) and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the published date indicated on the article and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Cornerstone to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Cornerstone, its officers, employees or agents. This material may contain ‘forward looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
Any accounting or tax advice contained in this communication is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
The information is provided solely for informational purposes and therefore should not be considered an offer to buy or sell a security. Except as otherwise required by law, Cornerstone shall not be responsible for any trading decisions or damages or other losses resulting from this information, data, analyses or opinions or their use. Please read any prospectus carefully before investing.
