Government Shores Up Liquidity
Most of the coverage of the changing regulatory landscape for banks has focused on capital strength, since the bursting of the real estate bubble made it clear that many banks didn't have sufficient reserves and core capital to cover loan losses. The perceived weakness in capital strength fed fears of a liquidity crisis, and large thrifts that failed early in the credit crisis, including IndyMac Bank and Washington Mutual, experienced alarming deposit flight before being shut down by the Office of Thrift Supervision and placed into Federal Deposit Insurance Corp. receivership in 2008. Following the closing of Washington Mutual -- the largest bank or thrift failure in U.S. history, with $307 billion in total assets when it when it failed in September 2008, after which the institution was sold by the FDIC to JPMorgan Chase ( JPM) -- the federal government took very strong measures to preclude additional retail runs on bank deposits. The Emergency Economic Stabilization Act was signed into law by President George W. Bush in October 2008, and included the $700 billion Troubled Assets Relief Program, or TARP, as well as a temporary increase in the basic individual limit on FDIC deposit insurance coverage to $250,000 from $100,000. The deposit insurance limit increase was later made permanent.
Stress Testing Liquidity
Mosby said that "by the end of 2008, our Large Cap Banks' coverage of a retail run on the bank had fallen below 100%," but because of actions by the FDIC and the Federal Reserve, "the coverage ratio for a retail run on the Large Cap Banks has risen to above 150%, the highest level we have seen in the 2000s. Additionally, wholesale and institutional coverage ratios have improved from below 200% to around 400% today." The analyst tested the liquidity positions of the large banks under three different scenarios, using Basel guidelines, but also factoring in U.S. banks access to borrowings from the Federal Reserve and the Federal Home Loan Banks (FHLBs), as well as historical bank-run data. The first scenario would be a runoff of wholesale funding. The second would be a loss of institutional funding. The third would be a retail run on deposits of 20%, since Guggenheim's "analysis has shown that about 20% of retail deposits will run-off in that scenario as depositors become worried that access to their accounts may become limited." Testing the above scenarios, Mosby estimated that the 15 large-cap banks covered by Guggenheim "could potentially lose $3.6 trillion of funding during a full-blown liquidity crisis. However, the sale of liquid assets, access to emergency funding from the Fed and the FHLBs, and the repo or sale of collateral could raise over $5 trillion. Thus, the median coverage for our Large Cap Banks is 171%." The Basel liquidity tests do not account for FDIC deposit insurance or FHLB access, because European banks don't have access to either. "As a result, the Basel guidelines incorporated the European level of expected run-off, which we have assumed is 30% for this analysis," Mosby said. Assuming the 30% deposit run, with no FHLB access, "the median coverage ratio from 171% to 138%," he said, adding that BB&T ( BBT) and U.S. Bancorp ( USB) "would fall short of covering their respective loss of funds in this scenario." Then again, "this liquidity crunch can be easily fixed today by lengthening borrowings outside the 12-month window incorporated into the liquidity crisis analysis, especially since long-term rates are currently so low."
Deploying Liquidity to Improve Earnings
Mosby said that from 2007 through the third quarter of 2012, "a potential unfavorable $3.3 billion hit to net interest income" from insufficient liquidity "has been reversed into a $29.1 billion earnings reserve waiting to be utilized," for the 15 large-cap banks under Guggenheim's coverage. Under Mosby's "base case" scenario, Bank of America could improve its quarterly net interest income by $3.8 billion, leading to an earnings increase of 20%. For Citigroup, quarterly net interest income could increase by $6.0 billion, with earnings-per-share increasing by 19%. For JPMorgan Chase, quarterly net interest income could grow by $9.9 billion, with EPS increasing by 34%. For wells Fargo, quarterly net interest income could grow by $3.5 billion, increasing EPS by 11%. The analyst said that "while banks would like, and historically have been able, to deploy liquidity into loan growth, it isn't the only option. When high quality fixed income securities get above 3.5%, Large Cap Banks could utilize some of this earnings impact without too much anxiety over underutilizing these assets." The trust banks could be looking at the biggest earnings potential from excess liquidity, as they "typically hold liquidity on their balance sheets and the recent deposit flight to quality has increased the impact that deploying these funds could generate today," according to Mosby. But it will depend on how quickly interest rates rise. "Our analysis suggests that BK, NTRS, and STT could improve earnings levels by 52%, 40%, and 25% by utilizing excess liquidity," Mosby said, but "in today's interest rate environment and due to the short-term nature of the recent inflow of deposits, it would not be prudent to deploy the majority of these available funds, but only utilizing 10% of the available liquidity capacity could significantly improve earnings in the short-run." -- Written by Philip van Doorn in Jupiter, Fla >Contact by Email. Follow @PhilipvanDoorn