Smaller and medium-size institutions who account for almost a third of all bank lending are currently experiencing deposit outflows. This has broader implications for their asset-liability management, liquidity position and ultimately market share. Referencing a credit sensitive element such as an Across-the-Curve Credit Spread Index (AXI) in new SOFR-based lending by smaller and medium-size banks can help reduce the likelihood and magnitude of deposit outflows to America’s largest banks.
Smaller and medium-size American banks play a critical role in the domestic economy. These banks support their local customers and businesses, create millions of jobs and help uplift communities. The events of the coming months, and the way these banks adapt to them, could have a profound impact on their future prosperity and on the customers they serve.
The recent failure of Silicon Valley Bank (SVB) could have had broader cascading effects across the regional banking community had it not been for the swift action taken by the Treasury Department, Federal Reserve and FDIC. Last Thursday, a collection of the largest American banks made a remarkable $30 billion uninsured deposit into First Republic Bank to support the economy after regional banks were experiencing deposit outflows. However, these actions alone do not appear to have been sufficient to quell market concerns.
One of the consequences of the SVB collapse is that bank customers who once considered their deposits to be risk free, were left questioning that assumption. As a result, smaller and medium-size American banks including large regional banks are currently experiencing deposit outflows, which has broader implications for asset-liability management, liquidity position and ultimately market share.
It was reported last week that “too-big-to-fail” banks had seen a sharp increase in customer deposits with Bank of America said to have taken in more than $15 billion in deposits.
Bloomberg reported over the weekend that a coalition of midsize US banks asked federal regulators to extend FDIC insurance to all deposits for the next two years, arguing the guarantee is needed to avoid a wider run on the banks. “Doing so will immediately halt the exodus of deposits from smaller banks, stabilize the banking sector and greatly reduce chances of more bank failures,” the Mid-Size Bank Coalition of America said in a letter to regulators seen by Bloomberg News.
Referencing a credit sensitive element such as an Across-the-Curve Credit Spread Index (USD-AXI) in new SOFR-based lending can help reduce the likelihood and magnitude of deposit outflows from regional banks to America’s largest banks. In doing so, smaller and medium-size banks will be in a stronger liquidity position and will be better equipped to defend their market share.
The interest rate paid by the borrower on a bank credit line that references USD-AXI in conjunction with SOFR tends to move higher in times of market stress, relative to a SOFR-only based loan. Referencing USD-AXI in a credit line creates a disincentive for borrowers to draw down at the higher implied rate in times of stress, like the market is currently experiencing. This means that credit lines would not be drawn as heavily at the high implied drawn rate.
In turn, this reduces the need for banks to go into the market to obtain new external fundings when deposits are being redeemed. We also know that this phenomenon disproportionally and adversely impacts regional banks. Recent empirical analysis by academics at the Federal Reserve Bank of New York and Stanford Graduate School of Business showed that regional banks can experience significantly less depositing of line draws during stressed times compared with the larger money-center banks.
The ability of banks to offer competitive rates on deposits could be bolstered when the banks lending is linked to both SOFR + USD-AXI. More attractive deposit rates could be offered because the banks are compensated by the higher implied lending yields in the event that customers do draw down. This helps to create a financial incentive for a customer to roll a deposit at a particular bank. In the current environment incremental compensation for the potential perceived changes in credit worthiness of the bank could help stem the outflow of deposits.
Last week we observed a substantial increase in the longer term underlying transaction volumes upon which USD-AXI is calculated. Studies can show whether this was the result of banks funding new credit line drawdowns by borrowers, or preemptive fundings to sure up balance sheets. At the same time, USD-AXI moved higher performing as intended, which means the incremental marginal costs on these new fundings also increased. Referencing a credit sensitive element in new SOFR-based lending can help offset this cost borne exclusively by banks, in doing so banks can promote elasticity in lending markets which supports the broader economy.
About the Author
Mr. Burnett is chief executive of SOFR Academy, Inc. and is based in New York City.