Authors: Liu Gang, Li Yujie, Yang Xuanting

Source: CICC Strategy

Core views

1. Where did the pressure on Bank of America come from? Losses on the asset side, loss on the debt side, and heightened anxiety levels of mismatch.

On the asset side, Bank of America's asset depreciation for the full year of 2022 was about 10%, and the worst 5% of bank asset depreciation was over 20%. On the debt side, deposits have flowed out 3% since the 2022 high, with low interest rates on deposits mainly due to the loss of large banks in the early stages, and the outflow pressure of small and medium-sized banks has increased recently.

Banks that have bigger problems on both the asset side and the debt side are more vulnerable. Silicon Valley Bank is a typical example.

2. How high is the overall pressure? Where is the weak link?

The results of the 2022 Federal Reserve stress test showed that the CET1 ratio of the 33 largest US banks fell to 9.7% at most (the regulatory requirement is 4.5%). According to NBER estimates, even if losses are taken into account, the assets of only two banks are unable to repay deposits. However, structural differentiation is quite obvious, and small to medium banks may be the weak link.

On the one hand, the overall asset adequacy ratio of small to medium banks is not as high as that of large banks; on the other hand, higher-risk businesses account for more in the business structure of small to medium banks, such as commercial real estate loans and CMBS securities. Furthermore, deposit losses, in particular, are nonlinear changes in the pressure amplifying the risk of crowding.

3. Where are you now? How to observe subsequent evolution? The possibility of a systemic crisis is low. Focus on credit contraction and the possibility that the market will induce risk by looking for risk.

Currently, the US is in a period of liquidity shock, and the transformation of liquidity pressure into large-scale debt pressure is usually triggered by high leverage and untimely intervention by the central bank. Currently, none of them are ready. However, in situations where emotions are sensitive, it is necessary to pay attention to bank credit contraction and the possibility of risk eruption caused by the market actively searching for risk points.

IV. What is the impact on policies and assets? Interest rate hikes are coming to an end, and liquidity support is the main tool; credit contraction in turn helps curb inflation.

The Federal Reserve's current policy direction is still to raise interest rates to control inflation. By providing emergency support through liquidity investment, the “treating the symptoms” policy may be more effective.

Looking back, the occurrence of a recession is still a probable event, and a certain degree of credit contraction will also help the Federal Reserve reach its inflation target.Therefore, we think interest rate cuts in the second half of the year may still exist. As far as assets are concerned, interest rates and gold are included in many expectations. After interest rate cuts, asset allocation can be driven to rotate from US bonds to US stock growth stocks.

Specific analysis

1. Where did the pressure on Bank of America come from? Losses on the asset side, loss on the debt side, and heightened anxiety levels of mismatch

The business model of borrowing short loans and the mismatch of terms is a natural attribute of banks, and it also meets their intermediary status requirements to integrate financial resources to match financial needs. However, this kind of business model will come under some pressure during the period when interest rates are rising rapidly. This is also the general background behind the frequent cases of financial institutions over the past period.

On the asset side, Bank of America's assets depreciated by about 10% for the full year of 2022.

Bank assets across the US are mainly composed of loans (56%) and holdings of securities assets (such as bonds, accounting for 27%). Higher interest rates will cause a loss in the fair value of this part of the asset. Since 2020, interest rates on 10-year US bonds have risen sharply to 370 bps. The rise in interest rates has not only suppressed the value of bonds, but also damaged the current value of their loan assets.

Bank of America's share of fixed-rate mortgage loans has remained at 80% to 90% since 2020, and it is difficult for banks to adjust their profitability according to the upward trend in interest rates.

According to FDIC estimates, as of 4Q22, US commercial banks and depository institutions had unrealized losses of about US$620.4 billion in marketable securities (AFS) and securities hold-to-maturity (HTM). According to NBER's estimates, compared to 1Q22, the total asset value of bank mark-to-market fell by about 2 trillion US dollars. The average impairment rate of each bank was 10%, and the worst 5% of bank asset impairment was over 20%.

Looking at the debt side, deposits have flowed out 3% since the 2022 high, with low interest rates on deposits mainly due to the loss of large banks in the early stages, and the outflow pressure from small to medium banks has increased recently.

By the end of February, the deposit size of commercial banks in the United States fell to 1.64 trillion US dollars, a decrease of 485.7 billion US dollars from the high in March 2022, accounting for 3% of their total deposits. However, internal fragmentation is obvious. Instead, the loss of upfront deposits was dominated by large banks (537.1 billion US dollars), while small banks still had inflows (140 billion US dollars). The reason for this is that in the interest rate hike cycle, the upward trend in commercial bank deposit interest rates lagged behind the upward trend in benchmark interest rates.

As of February 2023, the average interest rate for small deposits in the US was only 0.37%, far lower than the federal funds rate and overnight reverse repo rate (4.54%). This reversal has caused savers to transfer their deposits to: 1) monetary funds with higher interest rates. The size of the US monetary fund rose by 287 billion US dollars to nearly 5 trillion US dollars during the same period; 2) Smaller or online banks with higher interest rates on deposits.

Taking a 3-month deposit as an example, TotalDirect Bank's interest rate is 5%, which is significantly higher than the national average of 0.67%. This can also be reflected in macro data. M1 (high-liquidity deposits such as cash+current accounts) and M2 (M1+ time deposits and some monetary funds, etc.) have both turned negative year on year, but M1 declined even more (M1's year-on-year growth rate fell back to -4.55% in January 2023, and M2 grew -1.73% year on year).

Outflow pressure from small to medium banks has increased recently.

According to the latest data from the Federal Reserve, as of March 15, the previous continuous outflow of large bank deposits turned into inflows after the Silicon Valley bank incident occurred (inflow of 66.7 billion US dollars, accounting for 0.6% of total deposits), while there was a sharp outflow of deposits from small banks (an outflow of 12 billion US dollars, accounting for about 2.2% of total deposits).

It's easy to see that banks with bigger problems on both the asset side (high unrealized profit and loss, such as exceeding Tier 1 core capital) and the debt side (high customer concentration and single deposit size exceeding the $250,000 limit of FDIC deposit insurance) are also more vulnerable. The Bank of Silicon Valley is a typical example.

2. How high is the overall pressure? Where is the weak link?

Judging from the global static situation, the pressure is still within a manageable range.According to the Federal Reserve's 2022 stress test results, under a stressful scenario (stressful scenario), the total CET1 ratio of the 33 major US banks will drop from 12.4% in 4Q21 to 9.7% (the regulatory requirement value is 4.5%).

As of February 2023, the loan-to-deposit ratio of all local banks of 67.5% was also lower than the level of 76.4% at the end of 2019. Furthermore, according to NBER's estimates, even if bank assets are calculated using mart-to-market after unrealized losses are taken into account, almost all banks have sufficient assets to pay for their deposits not guaranteed by the FDIC, with the exception of two.

However, structural differentiation is quite obvious, and small to medium banks may be the weak link.

According to NBER estimates, the impairment ratio for systemically important banks was as small as 4.6%, the impairment ratio for large non-systemically important banks was 10%, and the impairment ratio for small banks was 9.1%. The reason for this is that, on the one hand, the asset adequacy ratio of small and medium-sized banks is not as good as that of large banks (global systemically important banks such as Morgan Stanley, Goldman Sachs, JP Morgan, etc., have a significantly higher CET1 ratio than small to medium banks), and on the other hand, the business structure of small and medium-sized banks accounts for more risky businesses, such as commercial real estate loans and CMBS securities (commercial real estate mortgage loans of small banks account for 44% of loans compared to 12.9% of large banks), so asset depreciation pressure may be greater.

However, at present, judging from the increase in CMBS interest spreads (far from reaching the level of the 2008 period) or the commercial real estate vacancy rate (the US office vacancy rate rose only slightly from 11.4% in 4Q19 to 15.4% in 3Q22), the overall risk is also within a manageable range.

Furthermore, the loss of deposits, in particular, the risk of crowding is a nonlinear change in the increasing pressure.Silicon Valley Bank is a prime example.

The US currently has a total of 9.2 trillion US dollars of unpaid deposits, accounting for more than 40% of all deposits. NBER's stress tests show that 1) if all unsecured depositors withdraw their funds, the deposit repayment ratio of 1,619 banks (33%) will be negative, with a total of about 2.6 trillion US dollars of deposits (15% of total deposits) or affected; 2) when 50% of unsecured depositors withdraw funds, a total of about 300 billion US dollars of deposits out of 186 (4%) banks will be at risk.

3. Where are you now? How to observe subsequent evolution? The possibility of a systemic crisis is low. Focus on credit contraction and the possibility that the market will induce risk by looking for risk

In the context of tightening overall financial conditions and rising financing costs, it is often easy to induce some weak link problems. However, the economic cycle, liquidity shocks, and debt crises brought about by rising financing costs are three levels of pressure, and they also need to be treated differently.

The US is currently in a period of liquidity shock, and the transformation of liquidity pressure into large-scale debt pressure is usually triggered by two conditions: high leverage and untimely intervention by central banks.Currently, the macro leverage ratio across the US is still at a healthy level after experiencing deleveraging through the subprime mortgage crisis (financial institution leverage ratio 75.8%, residential sector 72.5%).

The Fed's response was very timely this time, and it was also “treating the symptoms”. As can be seen from the discount window and BTFP tool usage on the Fed's balance sheet last week, the Federal Reserve has already assumed the role of the lender of last resort, so if you look at it statically,Currently, the possibility that a global risk will occur in Bank of America is manageable as a whole.Especially considering that the level of leverage in the residential sector is also relatively low.

However, in the current situation where emotions are sensitive, it is necessary to pay attention to the possibility that risk will occur due to bank credit contraction and the market's active search for risk points.The degree of abundant interbank liquidity in the US, the loan default rate (such as home mortgages, commercial real estate mortgages, consumer loans, etc.), and the pressure on corporate financing from tightening financial conditions due to declining willingness to invest in credit are indicators that require continued attention in the future.

At the level of high-frequency data, FRA-OIS spreads (measures interbank liquidity pressure), CMBS option adjustment spreads (measures default risk), credit spreads and commercial bill spreads (measures financing costs and credit risk), and the current value of CDS levels of large and systemically important banks is far from the 2008 subprime mortgage crisis period, including the current US commercial real estate situation that investors are concerned about.

IV. What is the impact on policies and assets? Interest rate hikes are coming to an end, and liquidity support is the main tool; credit contraction in turn helps curb inflation

The Federal Reserve's current policy direction is still to raise interest rates to control inflation and provide emergency support through liquidity investment.This can also be seen from the Federal Reserve's “middle course” choice at the FOMC meeting in March. The market previously anticipated that the FOMC in March might directly switch to interest rate cuts, but with inflation still at a high level of 5% to 6%, direct interest rate cuts may cause major secondary disasters, disrupting the anti-inflation forward-looking guidance expectations, making it more difficult to achieve the inflation target. Compared to direct interest rate cuts, current “treating the symptoms” liquidity investment may be more effective.

Looking back, we still think that the recession will occur is a probable judgment. At the same time, we insist on predicting that the US CPI and core CPI will fall back to around 3% and 4% respectively by the end of the second quarter under recession pressure. To a certain extent, the tightening of financial conditions and credit contraction caused by the recent banking incident helped the Federal Reserve achieve its inflation target (previously, the Federal Reserve continued to raise interest rates, but financial conditions were relaxed. The minutes of the February FOMC meeting also showed the Fed's concern about financial conditions).Therefore, we believe that the door to gradually start cutting interest rates in the second half of the year still exists.

In terms of the pace of time, some time to come will be critical.Risk exposure will be released in the short term mainly because the market spontaneously searches for risk. If sentiment gradually stabilizes over a period of time, then the risk will also be within the current manageable range, which in turn will help ease panic and make up for expectations that interest rate cuts are too steep. Interest rates on US bonds include a lot of interest rate cuts in the short term, or fluctuate at 3.5%.

As recessionary pressure rises and inflation rapidly recedes after 5%, a further decline in US bond interest rates will drive asset allocation to rotate from US debt to gold to US stock growth stocks.

Editor/phoebe