Reimagining Banking: Adapting to Modern Financial Landscapes
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The Evolution of Banking
As the banking landscape shifts, institutions like banks and credit unions face a pressing need for transformation. Following significant failures in the first quarter, these organizations must adapt to avert future challenges.
Recent bank collapses have thrust traditional banks and deposit structures into the limelight. Customers from regional banks, anxious about the safety of their funds, have rapidly transferred their deposits to larger institutions, effectively initiating a contemporary version of a 'bank run.'
This prompts the question: if there was such a high level of concern, why weren't these deposits already with larger banks? The answer lies in deposit interest rates.
At the start of the year, major financial institutions in the U.S., including Bank of America and JPMorgan Chase, were offering nearly 0% interest on accessible balances in accounts like checking and savings. This is in stark contrast to the Federal Funds Rate, which has soared above 4% over the past year and is expected to remain elevated.
Here's a closer look at the current dynamics within the industry and what we can expect moving forward.
Rapid Shifts in Retail Deposits
In today's fast-paced financial services environment, it is now feasible to transfer funds from one bank to another on the same day, at any time, using a mobile device or computer. The era of mandatory in-person transactions with checks or wire transfers at a bank branch—complete with the verification of physical IDs and signatures—is a thing of the past. This ease of transferring funds is now accessible not only through large banks but also mid-sized regional banks and small credit unions across the U.S.
Business clients, particularly those maintaining balances over $250K, represent a greater risk for deposit volatility. Institutions that are heavily exposed to specific business sectors are more vulnerable to significant withdrawals and liquidity issues during economic downturns, as seen with Signature Bank and Silicon Valley Bank (SVB). In the case of SVB, depositors withdrew over 35% of total deposits within just two business days.
For small and medium-sized enterprises (SMEs), deposit volumes are no longer stable. These businesses face challenges managing cash flow in a declining market. When you add consumer deposits into the mix, it becomes evident that financial institutions cannot depend on these funds to support corporate banking and treasury management functions, such as lending and long-term investments. If these inflows are primarily transactional and do not generate income for banks, what incentive is there to offer interest on them?
Low Deposit Rates Amid High Rates
Interest rates play a crucial role in maintaining customer loyalty to banks, also known as 'stickiness' of deposits. When these balances are not utilized by banks for lending or investment, they become more of a liability.
Established financial institutions typically have access to sufficient liquidity through long-term deposits, debt, and reserve requirements. This business model explains why many large banks are offering nearly 0% interest rates.
Conversely, regional banks depend on retail deposits from individuals and businesses to generate revenue. It's common to see promotional offers for new savings deposits of $10K or more. During my time at bank branches from 2006 to 2018, customers would often arrive with 'coupons' for bonuses (e.g., a $300 bonus for a $25K deposit held for 90 days). After the promotional period ended and bonuses were disbursed, customers would typically withdraw their funds to take advantage of better offers at other banks, perpetuating this cycle.
Larger banks are increasingly overlooking underserved customer segments, leaving these opportunities to smaller competitors. Major financial institutions recognize that they cannot cater to every customer's unique banking and credit requirements.
For small businesses to flourish, mid-sized banks must offer comprehensive deposit, lending, and other services. This necessity was evident for cryptocurrency firms that partnered with Silvergate and Signature Bank, as well as startups that relied on deposits with SVB.
Digital 'Bank Runs'
As depositors lose faith in their banks, outflows can surge from regional banks to larger institutions. Today's bank runs occur digitally, with electronic transfer requests initiated outside of bank branches. Payment systems like ACH and wire transfers facilitate the movement of funds from one bank to another.
In today's environment, mere speculation about a bank's stability can trigger panic, fueled by social media. Individuals often turn to platforms like Twitter to follow influencers' posts, and negative sentiment can quickly escalate, prompting depositors to rush to withdraw their funds en masse.
Even if regulators implement tighter controls, responding to all requests within a day or two during a panic is unlikely. The perception of a bank as high-risk can be sufficient to incite a rush.
Subsequently, top financial firms are inundated with new account applications and pressured to expedite their review processes. Even if small businesses are granted accounts, they may find a stark difference in service quality. The personal relationship with a banker may be weaker, and response times to inquiries could slow down. Unusual transaction activities, such as large incoming wires from investors, might be flagged or blocked.
This friction underscores a crucial point: larger banks are not structured to provide the same level of service to certain customer segments as mid-sized banks. Retail deposits often take a backseat for major institutions, which is why thousands of licensed credit unions and mid-sized banks thrive in the U.S.
Shifting Dynamics Ahead
The demand for business banking services across various sectors—from solo entrepreneurs to mid-sized firms—will persist. Given the significant economic contributions of the small business sector, banks will be essential for providing these companies with deposit, credit, and other banking services.
Moving forward, these banks will likely face heightened scrutiny from regulators, especially regarding exposure risks to specific sectors. Recent headlines indicate that regulators are seeking to increase capital requirements. Cryptocurrency remains a focal point for various agencies governing bank policy, as evidenced by actions taken against firms like Binance and Coinbase.
In the near future, regulatory oversight of smaller banks may evolve to ensure that adequate capital requirements are upheld. A balance must be struck between reducing the risk of bank runs and allowing institutions to utilize deposits for generating income. Poor investment decisions and delayed adjustments can also lead to losses, sparking future concerns about a bank's stability.
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