‘Black-body radiation’ – a phrase first dreamed up by Gustav Kirchoff in 1862 – is both a marvel of classic physics and a signal player in its undoing.
The multi-talented Kirchoff was the first to mathematically formalise the relationship between radiation falling on an idealised black body and the subsequent frequencies of heat energy emitted as determined by temperature.
Under his formulation, a black-body would absorb and emit energy of all frequencies. Essentially, scientists of the day imagined black-body emission as a sum of all the absorbed energy waves, a calculation which worked fine at lower frequencies but exploded into meaningless infinity when ultraviolet entered the picture.
It was Kirchoff’s German compatriot, Max Planck, who resolved the so-called ‘ultraviolet catastrophe’ in 1901 by restating continuous wave energy as discrete ‘quanta’ and – somewhat reluctantly – gave birth to what is now known as the ‘old quantum theory’.
Figure 1: Kirchhoff’s law
Flight to risk
In classical finance theory, banks absorb deposits and emit credit in risk-weighted frequencies that analyst’s study to understand the relative health of each institution.
Deposits form the basis of liquidity, which as we explained in an earlier Fiorino, is the essence of banking.
Throughout history, almost all bank catastrophes have been linked to evaporating liquidity triggered by deposit flight.
And while many believed the problem of large-scale bank runs had been resolved by elaborate central banking systems and deposit insurance schemes in most developed countries – especially since the global financial crisis (GFC) – the collapse of three significant US lenders in the space of a month this year has questioned that faith.
The shuttering in rapid succession of the Signature, Silicon Valley and First Republic banks in the US has refocused the attention of regulators, investors, and analysts on the finer points of deposit metrics that had previously been glossed over.
In the wake of the mini-crisis (and ongoing instability in the US regional banking sector), bank management teams across the Atlantic are talking up the virtue of their robust deposits. Meanwhile, corporates and small-to-medium enterprise (SME) treasurers are stashing more cash at banks ahead of a feared recession.
Some banks have seen deposit flight as retail clients chase cash returns in higher-yielding accounts of rivals, money market funds (MMF) or even short-dated government bonds.
Other banking institutions, however, are even encouraging retail banking customers to shift deposits to associated asset management products, including MMFs, that earn the business fees instead of paying out interest. Equity markets, for example, tend to value ‘fee income’ more highly than the old school ‘net interest income’ in bank profit-and-loss statements.
But we believe the US banking scare may be a little overdone.
Undoubtedly, US deposits are shrinking – in line with previous trends as central banks hike repo rates1 – but from a historically very high level. US deposits have been growing since before the GFC and, despite the current leakage, much of the cash is flowing to bank-related asset management products, as per the FDIC data below:
Figure 2: Y/Y change in total deposits at US banks
Interpreting the deposit spectrum
Yet top-line deposit levels can be misleading. Investors need to dig deeper into the details of bank deposits to truly understand the hidden risks across factors including:
- Deposit mix – an understanding of the combination of retail client current accounts, wealth management, SMEs and corporate deposits can offer insightful information: the more diversified the deposit base the better.
- Insured proportion – banks are disclosing, some for the first time, the split between insured deposits (US$250,000 in the US, €85,000 in Europe, and £85,000 in the UK – per account) and uninsured amounts, which can provide a useful indicator of flight risk.
- Peer comparison – any variations of a bank’s deposit mix versus home market competitors gives clues on commercial strategy, and any possible stress ahead.
- Historical deposit beta – or how much the bank is passing on to accountholders from central bank hikes, offers some guidance; and,
- Pace of deposit growth – especially if sustained, is a useful measure. For, as us credit analysts know, all banks are ‘ex growth’.
Investors, however, do have to keep a close eye on looming changes to the deposit system.
Amid the brewing uncertainty in the sector, the US Federal Deposit Insurance Corporation, the levy-funded organisation that backs the current US$250,000 account guarantee, is weighing up reforms to the scheme2. US politicians are resisting FDIC’s Option 2: a blanket guarantee of all deposits. The agency’s preferred route is option 3, targeted coverage, “[…] The account types that may merit higher coverage are those used for payment purposes, specifically business payment accounts”.3
The pass is getting narrower, too, as online banking and social media close the gap between slight concern and panic, which probably justifies a reassessment of the place of bank deposits in the financial system.
According to a CNBC report, the collapse of the ‘well capitalized’ Silicon Valley Bank in March this year followed a social media fear campaign spread by its venture capital customers after the institution signalled a plan to raise US$2.25bn to shore up the balance sheet.
“Within 48 hours, a panic induced by the very venture capital community that SVB had served and nurtured ended the bank’s 40-year-run,” the report says, as US$42bn fled.
Has social media and the widespread use of (some rather good) banking apps delivered an ultraviolet catastrophe for the post-GFC liquidity rules?
1 Deposits stand at US$16tn at present and are down 3% YTD, or US$494bn (seasonally adjusted) YTD through April 26th 2023. Source: FDIC.
2 See press release: https://www.fdic.gov/news/press-releases/2023/pr23035.html
3 See page 58 onwards: https://www.fdic.gov/analysis/options-deposit-insurance-reforms/report/options-deposit-insurance-reform-full.pdf