Signals: The small banks will be alright

Hey fintech friends,

Remember when SVB disclosed that its held-to-maturity portfolio was underperforming and businesses scrambled to wire funds out of their accounts and everyone freaked out on Jason Calanacis about this tweet? Because yeah, me too.

In the 2 months that followed, regional banks saw an aggregate $17.9 billion in deposits flow out to large banks and B2B fintechs (Brex, Mercury...) amid fears that smaller institutions might not have the reserves to back customers' deposits in the event of a wider bank run. Mass withdrawals sparked concerns that other banks would shut down, accelerating a trend of consolidation that's been eroding competition in the banking industry for the past few decades.

One year on from the SVB crisis, where have these deposits landed?

Let's dive into the current state of bank deposits, financial institutions’ priorities going into a stable(r) interest rate environment, and how fintechs are helping banks compete going forward.

Customers fled from banks of all sizes in the immediate aftermath of SVB's collapse, with the bulk of withdrawals taking place at 30 mid-size banks ($50B to $250B in assets). Large banks and community banks were largely spared from bank runs, but by May, outflows started to trickle back– particularly to the largest institutions and smaller community bank. 

The 1-year net effect: As of last April 2023, 

While overall bank deposits have declined since March 2023, smaller banks have increased their share of total deposits held from 32.3% a year ago to 32.9% today. This was driven by a few factors.

The FDIC reassured depositors of banks’ viability by bailing out over $33 billion in insured and uninsured deposits held at SVB, Signature Bank, and First Republic (and collected $9 billion from JP Morgan, Bank of America, Wells Fargo, and Citi to replenish its coffers for future bailouts).

Interest rate hikes spurred depositors’ appetite for yield. The volume of cash in money market funds, brokered deposits, and large time deposits (CDs >$100,000 in value) have now reached all-time highs– since the end of Q1 2023, 

Source: St. Louis Federal Reserve

It’s worth noting that regulators are keeping an eye on brokered deposits, as these funds are swept through an opaque inter-institutional network that could destabilize the banking system if not properly monitored. In February, Jason Mikula reported on a consent order that Lineage Bank entered into with the FDIC which, in part, concerned Lineage misclassifying $96 million-$124 million of brokered deposits in its regulatory filings.

Deposit flows have stabilized, but SVB’s collapse largely shifted the make-up of deposits towards higher-insured, higher-yield, and higher-duration products as compared to a year ago.  The higher cost of holding deposits is already eating into banks’ net interest income, and going forward, the challenge for banks will be to generate value on this cash amid flattening interest rates and a rocky macroeconomic outlook.

Leave bank runs in 2023. Today the biggest existential risk for banks is on the asset side of the balance sheet: Credit defaults– particularly in commercial real estate portfolios.

New York Community Bancorp is the latest bank to come under scrutiny after reporting that it set aside $552 million for losses in its souring CRE portfolio in January. Banks across the board are shoring up capital to face similar potential losses on commercial real estate; altogether, banks hold $920 billion in CRE loans, 90% of which is set to mature in the next 5 years. CRE loans are largely issued on office buildings, and because the market value of office space has tumbled since COVID (thanks again, millennials 🙄) office building owners are being pushed to refinance– or more likely, sell– the real estate at a massive write-down.

CRE portfolio losses drive new urgency for banks– especially smaller, less well-capitalized institutions– to diversify lending and attract loss-absorbing deposits. A good starting point could be to roll out the kind of treasury management solutions that took off in 2023. Brokered deposits were the fastest-growing form of deposits in 2023 because businesses wanted a safer place to park uninsured balances; Brex, Mercury, Crescent, and Vesto responded by popularizing FDIC insurance of up to $6 million and ~5% APY on business bank accounts. In August, Treasure launched an API that enables other companies to embed out-of-the-box treasury management within their own platforms. 

Regulatory response to SVB collapse also creates opportunities for community banks to better compete on loan products. Emerging capital requirements will raise large institutions’ cost of capital and, in turn, force them to raise rates on credit. These rules won’t apply to smaller banks, who’ll be able to offer more attractive APR.

Other features that banks can use to retain deposits: Real-time payment– 66% of community banks now plan to implement FedNow in the next 2 years– trade financing, multi-currency virtual accounts, automated wealth management…you get the idea.

Despite concerns, small institutions emerged from 2023 in relatively good shape. The Community Bank Sentiment Index reveals that community banks’ outlook is now improving, with small institutions managing to avoid an industry-wide bank run, to regain customers’ trust, and even grow their share of total deposits vs. large banks. On top of this, shifting product demands and regulation are driving opportunities for small banks to compete for an even greater share of deposits and loans from here.