Broker Check

Concerns about the Banking Industry

Concerns About Banks by chris@kilmerco.com

A quick disclaimer

I believe that there are many trustworthy banks in the banking industry. That is why I have trusted my savings with banks for my entire life. However, I have noticed some concerning trends lately which I wish to share with you. However, I wish to make it clear that I am NOT an expert at banking activities or regulations. Additionally, banking regulations are highly complex and convoluted. As of 2012, the Dodd-Frank Wall Street Reform and Consumer Protection Act had resulted in nearly 9,000 pages of regulations which are filled with thousands of references to other regulations. I have done my best to decipher what these regulations mean for depositors like you and me, but the odds that I have missed or misunderstood something is worth mentioning. I therefore strongly suggest that you do your own due diligence before taking any action.

A brief history on banking…

When you deposit money into a bank account, you are lending the money to the bank. You become an unsecured creditor of the bank. You no longer own that money. The bank does.

Banks often invest their assets into derivatives which are meant to help lower the risk of banks. However, derivatives can also be used to drastically increase a bank’s risk.  A major cause of the 2008 Financial Crisis was the misuse of mortgage-backed securities derivatives by many large banks. The U.S. government prevented these banks from failing by writing a check for $700 billion and then passing on the costs of that “bail-out” to American taxpayers. This is why Warren Buffet once said "derivatives are financial weapons of mass destruction".

In 2010, the U.S. government passed the Dodd-Frank Act which dictates what will happen if a bank is failing and its failure risks causing a banking crisis. The U.S. government will not use taxpayer money to save a bank from failure (see here). Instead, the FDIC takes receivership of the failed bank’s assets, including its deposits. The FDIC then pays out the bank's assets in a specific order to those the bank owes money to (see here). Any costs associated with the bank’s failure will fall upon the bank’s creditors and investors. This is known as a “bail-in”.

The bail-in strategy was first used in Cyprus shortly after the 2008 Financial Crisis. Failing Cyprus banks shut down their branches for two weeks in order to prevent mass withdrawals. They then instituted a bail-in. About 7% of every government-insured deposit less than €100,000 was seized. About 10% of every larger deposit was seized. Depositors were given stock in the failing banks as compensation for their lost savings.

What’s the problem?

It seems as though the derivatives market is in a similar position today as it was during the 2008 Financial Crisis. The notional value of the world's derivatives market was $672 trillion in 2008 and $632 trillion in 2022. The difference is that our banks and economy are not as prepared as in 2008 to weather such a crisis.

  • The net unrealized loss of U.S. banks grew from $74 billion in 2008 to $620 billion in 2022.
  • In March of 2023, the FDIC Chairman Martin Gruenberg said “The current interest rate environment has had dramatic effects on the profitability and risk profile of banks’ funding and investment strategies...Unrealized losses weaken a bank’s future ability to meet unexpected liquidity needs..."
  • That same month, the Moody's Investor Service changed its outlook on the U.S. banking system from "stable" to "negative" due to concerns about how high inflation, monetary tightening, and rising interest rates were likely to hurt banks by increasing depositor withdrawals and encouraging defaults on auto and credit card loans issued by banks.
  • Our world’s debt has tripled since 2008. U.S. debt reached $31 trillion and global debt reached $300 trillion in 2022.

Also different is that the U.S. government will not use taxpayer money to bail-out failing banks. One option is to have the banking industry pull together the funds necessary to cover the losses of any failed banks. This is known as a "special assessment". However, there is only so much that U.S. banks can do to help out before the entire banking industry is put at risk. Should the next crisis be large enough, the U.S. government may have no other choice than to institute a bail-in so that depositors must take on the burden of the losses themselves. 

What is concerning is that the order in which bank assets are to be paid out during a bail-in does not even mention depositors. Only unsecured creditors, which is what a depositor is to a bank. Derivatives are near the top of the priority list to be paid back, while unsecured creditors are nearly last in line (see here). Since depositors are considered to be unsecured creditors, does that mean that depositors are one of the last to be paid back? If so, what are the odds that the failed bank will have any assets left to pay back depositors after it pays back billions of dollars in derivatives claims?

Can banks touch your FDIC insured deposits?

The FDIC maintains a reserve of money which is funded by mandatory contributions from the banking industry. This reserve is used to refund up to $250,000 of a person's deposits in the event of an FDIC-insured bank's failure. The FDIC has assured that it will refund FDIC-insured deposits even in the event of a bail-in.

However, in September of 2022, the FDIC had only $125 billion in reserves to insure $9 trillion of U.S. bank deposits. Even if the FDIC tried to pay back depositors in the midst of a banking crisis, the FDIC can reimburse only about 1% of all bank deposits it has promised to protect. Normally, the FDIC will require U.S. banks to make mandatory contributions until FDIC reserves are replenished. But that can only go on for so long before the entire banking industry is put at risk of failure. The U.S. government has also made it clear in the Dodd-Frank Act that it will not use taxpayer money to financially assist a failing bank (see here). Therefore, it is unlikely that the government will replenish the FDIC’s reserves in order to repay the failing bank’s depositors.

How might Americans respond to this news?

This information is meant to help you be prepared for the next possible financial crisis. It is not meant to make you scared. However, the Toilet Paper Crisis of 2020 taught us that people often act on fear first and logic later. So what happens if people learn about bail-ins? Will they take a measured and prudent approach or will they stampede for the nearest bank branch and demand their money?

Are banks prepared for mass withdrawals?

The Federal Reserve has historically required that U.S. banks hold a minimum amount of cash in their vaults to cover sudden withdrawals. That way depositors would be able to get the money they need even if there was a run on the banks. The Reserve Requirement is calculated as a percentage of a bank’s total assets depending upon the size of the bank. The Reserve Requirement was as high as 10% of total assets for America’s large banks in January of 2020. In March of 2020, the Federal Reserve reduced Reserve Requirements to 0% in response to the Covid Pandemic. This means that banks were no longer required to hold any cash in their vaults to meet depositor withdrawals. As of January of 2022, this Reserve Requirement of 0% was still in effect.

Three major U.S. banks failed in March of 2023. Two of these represented the 2nd and 3rd largest bank failures in U.S. history. The primary cause was depositors making mass withdrawals due to issues in the tech and cryptocurrency industries. None of the three banks were prepared to meet the withdrawal demands of their depositors. They were forced to sell bonds at a loss to fund withdrawals and even then could not meet depositor demands. All three banks ultimately failed. As of 03/13/2023, the U.S. government promised to refund the depositors of two out of three of the banks. They assured Americans that taxpayer money would not be used to pay for this bail-out. Instead, the cost of refunding depositors would be paid for by a "special assessment", or mandatory contribution, from the U.S. banking industry. No bail-ins were initiated. Even so, bail-ins remain an option for U.S. regulators should our nation face any future banking crises.

If this is true, then what does that mean?

Banks technically own our deposits. We are just unsecured creditors to the bank.

Banks are using our deposits to invest in potentially risky derivatives. Derivatives played a major role in causing the 2008 Financial Crisis. The derivatives market is now as large as it was immediately prior to that crisis.

Our world is in a much worse financial state than it was in 2008. It may not be able to handle another banking crisis well.

The government can initiate a bail-in if a bank is large enough that its failure might result in a banking industry crisis. Should it carry out a bail-in…

  • The bank’s assets, including our deposits, will be used to pay back those the bank owes money to.
  • There is an order of priority for who is paid back first. Derivatives claims are near the top. Unsecured creditors are near the bottom. Depositors are often considered to be unsecured creditors to banks.
  • If the bank has to pay back billions of dollars in derivatives claims before paying depositors, then there may not be any money left to pay back depositors.
  • The FDIC does not have enough money to refund depositors in a banking crisis. Congress will not use taxpayer money to make the depositors whole.
  • Depositors might receive stock in the failed bank as compensation for their lost savings.

There might be a run on the banks if Americans realize that this is true. Banks currently do not hold enough cash in their vaults to cover such a situation. Their most likely course of action will be to temporarily close their branches in order to prevent mass withdrawals.

How might we better protect ourselves?

Not limit our savings to only ultra-large banks. These are the banks which are most likely to experience a bail-in and are often the same banks which heavily invest in derivatives.

Maintain accounts at more than one bank. That way we still have access to some money in the event that one bank fails.

 Ask any bank we use…

  • Who owns my deposits; me or this bank?
  • Am I considered an unsecured creditor to this bank?
  • Does this bank use deposits to invest in derivatives? If so, how much?
  • If this bank begins to fail, can it use my deposits to remain solvent as according to Title 2 of the Dodd Frank Act?
  • What percentage of your assets do you keep as cash in your vault for sudden withdrawals?

Keep enough cash at home to cover at least a month of living expenses in case banks ever close their branches to prevent mass withdrawals. Think of the run on toilet paper in 2020. Wouldn’t it have been nice to have a few extra rolls at home while you waited for the stores to re-stock?

Why are we telling you this?

There may be a dark cloud on the horizon for our nation’s banking industry. It is entirely possible that this cloud will pass us by without causing a storm. But if it does rain, we hope that this message will help you and your loved ones to be better protect yourselves.

Disclosures

The opinions provided in this presentation are that of the author and not United Planners. This presentation is meant for educational purposes only. Information presented should not be considered investment advice or a recommendation to take a particular action. Always consult with a financial professional regarding your personal situation before making any financial decisions. Kilmer & Company does not guarantee the accuracy or comprehensiveness of the information provided within this presentation.

References

A quick disclaimer

https://www.ibtimes.com/dodd-frank-rules-nearly-9000-pages-its-less-one-third-finished-726774

A Brief History on Banking

  • New York Federal Reserve, “Why Bail-ins? And how!”, page 3 found at https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412somm.pdf
  • Banking Regulation of UK and US Financial Markets by Dr. Dalvinder Singh, page 83
  • https://www.thebalancemoney.com/role-of-derivatives-in-creating-mortgage-crisis-3970477
  • https://www.nbcnews.com/id/wbna26987291
  • Letter from Warren Buffet to Berkshire Hathaway shareholders on February 21, 2003, page 14
  • https://www.theatlantic.com/business/archive/2013/03/everything-you-need-to-know-about-the-cyprus-bank-disaster/274096/
  • https://www.forbes.com/sites/nathanlewis/2013/05/03/the-cyprus-bank-bail-in-is-another-crony-bankster-scam/?sh=2e741c5b2685

What's the Problem?

  • https://www.reuters.com/investigates/special-report/usa-swaps/
  • Bank of International Settlements OTC Derivatives Outstanding, Global OTC derivatives market: Foreign exchange, interest rate, equity linked contracts and Commodity contracts, credit default swaps reports updated November 30, 2022 found at https://www.bis.org/statistics/derstats.htm
  • https://fred.stlouisfed.org/series/NUGLCBW027NBOG
  • https://www.fdic.gov/news/speeches/2023/spmar0623.html?source=govdelivery&utm_medium=email&utm_source=govdelivery
  • https://www.cnn.com/2023/03/12/investing/stocks-week-ahead/index.html
  • https://www.msn.com/en-us/money/personalfinance/moodys-downgrades-us-banking-systems-outlook-to-negative-citing-bank-runs/ar-AA18CIYD
  • https://fiscaldata.treasury.gov/datasets/historical-debt-outstanding/historical-debt-outstanding
  • https://fiscaldata.treasury.gov/americas-finance-guide/national-debt/
  • https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/visualizing-global-debt
  • https://www.interregional.com/en/global-debt/
  • https://www.kilmerco.com/how-rising-interest-rates-are-hurting-banks

Can banks touch your FDIC insured deposits?

  • Letter from the FDIC Legal Division to Mr. David Schroeder about his “Wall Street’s Worst Nightmare” advertisement on March 18, 2020. The letter can be read at https://www.fdic.gov/news/press-releases/2020/pr20037a.pdf
  • Letter from the FDIC Legal Division to Mr. David Schroeder about his “Wall Street’s Worst Nightmare” advertisement on March 18, 2020. The letter can be read at https://www.fdic.gov/news/press-releases/2020/pr20037a.pdf
  • https://www.fdic.gov/analysis/quarterly-banking-profile/fdic-quarterly/2022-vol16-4/fdic-v16n4-3q2022.pdf

How might Americans respond to this news?

  • None

Are banks prepared for mass withdrawals?

  • https://www.clevelandfed.org/publications/economic-commentary/2020/ec-202005-evolution-bank-capital-requirements
  • https://www.federalreserve.gov/monetarypolicy/reserve-maintenance-manual-calculation-of-reserve-balance-requirements.htm
  • https://www.clevelandfed.org/publications/economic-commentary/2020/ec-202005-evolution-bank-capital-requirements
  • https://www.thebalancemoney.com/reserve-requirement-3305883
  • https://www.kilmerco.com/large-bank-failures-in-march-of-2023
  • https://worthly.com/business/largest-swiss-banks-world/
    https://www.reuters.com/business/finance/credit-suisse-logs-worst-annual-loss-since-global-financial-crisis-2023-02-09/

How might we better protect ourselves?

  • Congressional Research Service, Bank Systemic Risk Regulation: The $50 Billion Threshold in the Dodd-Frank Act, Page 1 found at https://crsreports.congress.gov/product/pdf/R/R45036/5

These referenced sites are provided for informational purposes only and should not be viewed as an endorsement, sponsorship, solicitation or other affiliation with respect to any third parties or their content. United Planners Financial Services has not reviewed the content of, and are not responsible for, the information on any third-party websites.