Lessons From the Liquidity Crisis

Not only did the 2023 liquidity crisis result in the demise of three banks, it also siphoned deposits from many regional banks and brought a significant decline in their stock prices. What led to the failures? And what lessons can bank management and directors learn from what transpired? 

Before focusing on the issues affecting these three banks, let’s explore historical bank crises. Bank failures are often brought on by recessions. This was true in the 1980s, 1991, and 2007. What’s typically the issue? Credit problems arising from a recession are the normal trigger. In 2020, the pandemic prompted a recession. In the first quarter of 2020, real GDP declined 5.1%. In the second quarter GDP declined by 33%. It was one of the shortest recessions in history, but also one of the deepest. Yet no banks failed in 2020, and three banks failed in 2023 independent of a recession. 

Instead of credit risk, the recent failures were all associated with liquidity risk, interest-rate risk, and runs on deposits. A major lesson for board members and management is that other risks matter, too. Let’s look at some.               

Asset Growth 

In 2020 and 2021 the banking industry experienced unprecedented balance sheet growth, driven by COVID-related events including the Payroll Protection Program (PPP) lending initiative and the surge in deposits fueled by CARES Act (2020) and American Rescue Plan (2021) stimulus checks. But the three banks that failed in 2023 grew at much higher rates than the industry. In one case, most of the growth was driven by new customer relationships fueling deposit growth. In another, loans and deposits grew at about the same rate. And a third bank had loan growth, but deposit growth grew at a higher rate.         

Asset growth matters. Growth has benefits, of course. It helps leverage operating expenses and reduces the non-interest expense ratio. But there are concerns, as well. High growth rates can reduce the loan-to-asset ratio, which negatively impacts the yield on assets and ultimately the net-interest spread. 

This is exactly what happened at one failed bank. Between 2019 and 2021, its marketing department and relationship managers were achieving great success increasing the deposit side, but the asset-liability management (ALM) team was forced to move most of the money into investments instead of loans, negatively impacting the loan-to-asset ratio, the yield on assets, and the net interest spread. This dramatic growth in deposits can also distort the distribution of deposits and dilute the value of basic checking accounts. 

Lesson: Pay attention to asset growth rates. As noted, many banks grew at relatively high rates during COVID, but the change was not comparable to the balance sheet growth of the banks that failed. Ask questions: Where is the growth coming from? How are we employing the growth in our asset structure?  

Liquidity Risk 

Liquidity management is critical to effective asset-liability management. In 2020 and 2021, most banks were awash with liquidity due to lower loan demand and the aforementioned surge in deposits, all linked to the pandemic. The problem in this period was not liquidity risk, but rather excess liquidity earning nine basis points at the Federal Reserve or the Federal Home Loan Bank. This began to change in 2022 as loan demand picked up and banks began to experience deposit outflow in the third and fourth quarters due to rising short-term interest rates and higher pricing by competitors. The outflow of deposits continued into the first quarter of 2023. 

Liquidity risk matters. In 2022, one of the failed banks lost $16 billion in deposits even as it increased pricing from 15 basis points to 148 basis points on transaction accounts, primarily Money Market Deposit Accounts (MMDAs), in 2022. The other failed banks experienced similar outflows while also increasing deposit rates. We need to keep in mind that deposit outflows were occurring across the banking industry. The difference is that many banks had sufficient liquidity to handle the problem. Therefore, few banks had to sell investments at a loss to handle the liquidity issue. Taking a $1.8 billion loss on an investment sale appears to be one of the key events that led to one of the failures. 

Lesson: Look at your bank’s stress test results. In the financial crisis, the failure of Lehman Brothers in September 2008 was basically a liquidity event. The investment bank held subprime mortgage-backed securities that could no longer be used as collateral for borrowing. In 2009, in response to the financial crisis, regulators began to require stress testing on all banks. Since then, banks have been required to create a contingency funding plan that involves modeling both moderate and severe cases of events that could lead to a liquidity crisis—and identifying secondary sources of liquidity to address a crisis. Finally, banks need to conduct stress tests using their current cash-flow pro formas, again under moderate and severe levels of crisis. (Many individual banks use more than two scenarios). These tests demonstrate how the pro forma cash flow is impacted by internal or external events and how the bank is going to resolve the issues discovered.      

All banks are required to do a quarterly stress test, and the level of sophistication increases as bank asset size increases. Directors at all banks should review management results on a quarterly basis.   

Interest-Rate Risk 

Interest-rate risk was not a regulatory focus in 2020 nor 2021. Interest-rate risk is normally not a high priority when short-term interest rates are close to zero, as they were from March 2020 to March 2022. Having a mismatched balance sheet—that is, longer-term assets (residential mortgage loans, CRE loans, long-term investment securities, etc.) funded by relatively short-term deposits that are rate sensitive (MMDAs, for example)—is only possible if interest rates remain close to zero. In fact, one failed bank had a relatively stable net interest spread through the third quarter of 2022. But as the Fed continued to increase short-term interest rates, the spread began to narrow significantly in the first quarter of 2023.     

Interest-rate risk matters. Banks can weather balance sheet mismatches in the short run, whether the mismatch is short-term funding supporting long-term assets or long-term funding supporting short-term assets. But this is likely to catch up with a bank’s asset-liability committee (ALCO) in the longer run. If managers and directors look at history, they will notice that market interest rates eventually revert to the mean. In other words, if rates are at historically low levels, as in 2020 and 2021, they will at some point revert to higher rates. A mismatched, liability-sensitive balance sheet works fine when rates are at the bottom. But as market rates rise (especially short-term rates, which moved from 0-25 basis points past the mean to 475-500 basis points in just a year) those same balance sheets quickly cause serious trouble. 

As a footnote, part of blame for the recent crisis has been focused on the Fed, Chairman Jerome Powell in particular. The argument is that no bank could withstand a move of 500+ basis points in 12 months. This puts tremendous pressure on asset-liability management in the banking industry. But keep in mind over 99% of banks did not fail, as most had effective asset-liability management and did not take the level of interest-rate risk some failed banks did. Net interest spreads have tightened in all peer groups, and this is to be expected as short-term rates have increased more than long-term rates. Most banks have weathered the storm. 

Lesson: Pay attention to interest-rate risk. How would a change in market interest rates affect your balance sheet and income statement? Since 1996, most banks (and all banks over $100 million) have been required to conduct a quarterly simulation to determine earnings at risk (net interest income) and capital at risk from a +/- 100 to +/- 400 basis points change in interest rates. The results of the simulations are reported to the board on a quarterly basis. One caveat is that these simulations require managers to make assumptions, and some of the most important assumptions are related to the sensitivity of non-maturity deposits, especially money market deposit accounts.         

Diversification Matters 

Board members and managers are cognizant of diversification’s importance in a loan portfolio. They strive for a larger number of individual borrowers and look for geographic and industry diversification in commercial loans. Loan portfolio diversification is as important as underwriting. But until recently there was not a focus on diversification in the deposit base. At one failed bank a large majority of deposits were from the same industry—tech—and many arrived at the bank from the same source: investment bankers following an IPO. Of all the reasons for this particular failure, perhaps the most important was the common linkage within the customer base. Also, looking at the concentration in MMDA (76%) and uninsured (76%) deposits at this bank, it’s easy to see why interest-rate risk became unmanageable. The other failed banks had better deposit diversification, but also had customer bases that reflected industry concentration.            

The demise of these three banks has had a negative impact on many regional banks, especially those with over $100 billion in assets. These banks experienced greater deposit outflows starting in March 2023 and stock price declines. Directors and managers would benefit from reviewing their own business models and comparing them to the three banks that made headlines. Most regional banks have little in common with those that failed. And in community banking, there are very few banks that have anything in common with them. This is why the threat of contagion has not fully materialized. 

The liquidity crisis and bank failures of 2023 underscore the importance of banking fundamentals. It is crucial for banks to diligently monitor asset growth, liquidity rate risk, and interest-rate risk. It may sound rudimentary, but these things matter. 

James Clarke is a principal at Clarke Consulting. He is also a member of  The RMA Journal’s Editorial Advisory Board.