2024 CLFP Recertification

Educational Content: Sources of Funding/Capital Allocation

Capital Allocation

In March 2023, three U.S. banks failed, two of which were among the 30 largest U.S. banks at that time. The fallout from those failures has prompted lenders and lessors to carefully consider their capital bases, sources of capital, and risk/reward appetite.

What went wrong with the banks that failed? According to the U.S. Government Accountability Office, the primary drivers include:

1. Limited market focus and rapid growth

Over the period from December 2018 to December 2022, one institution’s assets more than doubled, while another’s more than tripled. Rapid growth by any company, regardless of the industry, requires a strong and reliable capital base. These two institutions funded their growth primarily with deposits uninsured by the FDIC. While individuals and consumers consider a deposit an asset, banks view deposits as liability accounts, as they are obligated to return the funds to depositors when they want their money back.

Certain industries can experience rapid growth during various economic climates. For example, during the height of COVID, technology became increasingly important as employees and students were sent home to work and study virtually. Further back in history, real estate also grew rapidly. When the economy changes, companies actively involved in certain industries can be significantly impacted to the point that they need to withdraw their deposits to pay their bills.

As these banks expanded their assets (loan portfolios and investment portfolios), their reliance on stable deposits became more important. Unfortunately, when multiple depositors rushed to withdraw funds, the institutions did not have the liquidity readily available to satisfy the requests. While the impact was felt most by a few institutions, the entire banking industry was affected due to concerns of more withdrawals simultaneously and the potential for a repeat of the run on banks during the Great Depression.

2. Investment portfolio and rapidly increasing interest rates

When interest rates rise, certain investments (such as long-term bonds earning a lower interest rate compared to newly-issued bonds at a higher interest rate) can lose value because there is little interest from others to purchase lower-rate investments. Even if an investor has no intention of selling such investments and plans to hold them until maturity, the value of the investment declines. In a scenario where depositors wish to withdraw their deposits, a financial institution might be forced to liquidate its investments into cash at a loss, potentially a significant one.

While there are investment strategies to reduce risks associated with rapidly rising or declining interest rates, this risk management strategy comes at a cost and seems to not have been appropriately employed by some institutions.

Regulatory requirements mandate that certain large banks identify unrealized losses in their investment portfolios, which diminishes their regulatory capital position. Following the March 2023 bank failures, the industry has focused on building capital and allocating it to the most profitable opportunities. Additionally, an international regulatory requirement known as Basel III, developed after the 2007-2009 financial crisis, is anticipated to lead to increased capital requirements for banks.

In order to increase capital, companies primarily retain earnings and/or issue stock. To enhance earnings for retention, companies strive to improve profitability through higher revenues and/or lower expenses. Banks aim to bolster earnings by earning more on their loans and leases (revenues) and minimizing losses (charge-offs) and lowering expenses. This inevitably leads to tighter credit parameters and higher rates for the use of the bank’s capital.

Reference material: “March 2023 Bank Failures—Risky Business Strategies Raise Questions About Federal Oversight” by U.S. GAO