Should you trust the banks with your hard earned money?

In the current backdrop of a bear market, a year into aggressive rate hikes by the Federal Reserve, we started witnessing cracks appear in the financial plumbing of the economy with the events surrounding bankruptcy of Silicon Valley Bank (SIVB) and Signature Bank. The big losses experienced by the banks are directly related to the surge in interest rates over the past year, as the company's US Treasury holdings were bought at a time when interest rates were still relatively low. Bond prices fall as yields rise. SIVB, a previously high-flying tech-related bank, suffered a cash/deposit crunch and was forced to liquidate bond holdings at a loss.

Since 2010, after the 2008 economic crisis triggered through the housing market, the Fed has been carrying out supervisory stress tests for large banks. These tests are conducted annually to show how the banks are likely to perform in a recessionary environment. The results of these tests under the "supervisory severely adverse scenario" are used to set capital requirements for large banks. While many may have been convinced by the actions after the 2008 financial crisis that another such crisis will not again happen in our lifetime, it appears that certain things have a way of repeating themselves.

Based on research done by Avi Gilburt, an Elliott Wave market analyst and founder of ElliotWave Trader (Elliottwavetrader.net) and Renaissance Research, in the stress test, some of the crucial areas to gauge the health of large banks have been missing[1].

• The largest part of securities held by banks are U.S. bands, municipal bonds and corporate bonds. In a rising rate environment, the longer-term bonds could lead to huge losses. Currently the Fed stress test does not estimate potential trading losses conservatively. This was the case for SIVB when USTs lost a significant portion of its value.

• Large banks also hold tens of trillions of over-the-counter derivatives on their balance sheets and off-balance sheets. These contracts could pose enormous risk in a volatile environment with a high chance of counterparty default. Currently the estimates of counterparty-related losses are reported by the banks and are not very reliable especially for over-the-counter derivatives. Hedging is absolutely essential for all the assets and derivatives.

• The issue of a large maturity mismatch between their assets and liabilities of banks is not being tested. For example, a high percentage of bank’s securities have maturities longer than 10 years, but the average maturity of the deposit book is likely less than 10 years. Such mismatch would likely lead to major liquidity issues and be a significant risk for depositors. This was exactly what happened with SIVB when they short term deposits to purchase long term USTs.

Unfortunately SIVB tripped on all the above issues. In general, banks are required by law to buy US Treasuries. SVB, out of incompetence or greed, optimized for yield, not liquidity, had to sell for heavy loss in face of deposit crunch. Nor were they required to hedge those positions by the stress tests, and they sure did not.

The brewing crisis is that the Fed needs to trigger a recession (with job loss) to bring down inflation, because the root cause of the inflation is that there are too few workers for the available roles in the current structure of the economy, and so the economy needs to be refactored to drop non-critical industries and inefficient firms. But that's going to cause a cash crunch, since laid-off workers start pulling cash out of banks instead of making it at their jobs. Plus many consumers are drawing down on their savings and going into debt now because of inflation. And it's going to happen right at the greatest velocity of interest rate increases, when Treasuries are at their lowest. So we're going to see bank failures on top of job losses, right as interest rates hit their highest.

Lots of these current financial issues are the far reaching impact of the COVID-10 lockdown policy. Shutting down the economy, stopping trade, stopping people and having the government step in printing money and dropping the interest rates to zero to hand over to corporations and for people to stay at home. It also uses its ability to create money to finance its own spending by buying its own debt securities, such as government bonds or treasury bills, in the open market. Essentially, the government is printing money to pay for its own expenses instead of relying on traditional sources of revenue, such as taxes or borrowing from private lenders. The practice of printing money and writing giant checks is not a winning strategy. It can have significant economic consequences, including inflation, and devaluation of the currency, among others. It is generally considered risky and can lead to long-term economic instability if not managed carefully.

So what should you do with your hard earned money? Avi working with Renaissance Research a little over two years ago, began to look for some of the strongest banks in the United States. They follow a rigorous methodology shown at: https://www.saferbankingresearch.com/methodology-banks, which addresses the missing pieces in the current federal stress test. Based on that, they came up with the top 15 banks across the nation out of 4000 banks. If interested, please check out their website: https://www.saferbankingresearch.com

[1] The Fed is trying to pull a fast one, https://www.saferbankingresearch.com/article/The-Fed-Is-Trying-To-Pull-A-Fast-One-20230220675.html