Next Banking Crisis

So many times, it happens so fast
You trade your passion for glory
--Survivor

One of the more thought provoking articles I've read in some time on the basis for the next banking crisis. Peter Atwater proposes that the next crisis will not driven by too little capital since banks have been busy shoring up their balance sheets since the 2008 credit market meltdown.

Instead, the next crisis will be grounded in where banks get their funding.

Because interest rates have been suppressed to uber low levels for a prolonged period of time, banks have been converting time deposits to transaction accounts (a.k.a. demand deposits)  in order to preserve interest rate margins. Because time deposits are costlier than demand deposits in terms of interest expense and other costs, this conversion has helped bank profits.

The problem is there is little lock-in with demand deposits. A deposit book that is heavily weighted toward demand deposits is susceptible to large, collective withdrawals by depositors (a.k.a. a 'run').

To keep depositors during turbulent times, banks will have to pay more to keep customers (i.e., raise interest rates). Atwater suggests that banks have not generally planned for a scenario where deposit costs are rising at the same time that longer dated Treasuries rates are falling due to a slower economy. Net interest margins would be compressed in such a situation.

Because their investment portfolios are so large today compared to deposits, banks might counter that they could weather this situation by selling or repo-ing securities to cover deposits. However, credit markets become less liquid during economic downturns, meaning lower prices for sellers. Moreover, investment banks carry less inventory today due to changing regs and lower risk appetites and will likely be less willing to trade with depositing institutions.

Atwater also suspects that bond funds will be sources of funds to meet redemptions, meaning that fixed income managers and bank treasurers will be correlated sellers (read: selling cascade).

In the end, Atwater comes full circle, proposing that today's higher capital ratios are a function of loan loss releases and higher fixed income asset prices. Take those factors away, and capital once again becomes dear--particularly during a lending strike.

From where he sits, Atwater thinks rollover risk will be central to the next banking crisis. It is in plain sight for those willing to open their eyes.