The Banking Crisis Is Bad, And Three Things Could Make It Worse

The regional banking crisis might be taking a back seat to the US debt ceiling countdown for now, but don’t go thinking this one is over. The troubles in the financial sector are still very much rumbling and they could flare up again. The way I see it, there are three major reasons to worry about banks – and they’ve got me steering well clear of their stocks.

1. The stock price influence

Confidence is everything for a bank. A falling stock price can strangle that confidence, shaking a bank to the core. With most other industries, stock price performance is the outcome of business performance – not the other way around. Think about McDonald’s for example. Falling share prices there won’t impact your decision to indulge in a Big Mac and fries, and, ultimately, real-life things like sales and profit tend to stabilize the stock. See, if McDonald’s share price falls far enough, it’ll start to look cheap relative to those sales and profit, and that’d entice investors back in. But it’s a whole different ball game with banks. A bank’s “products” are its loans, and it can’t make those without borrowing the money first, in the form of deposits. (It helps, here, to think of deposits as just low-interest loans to banks.) Now, as we’ve seen in recent months, falling stock prices on banks can get depositors worried, leading them to yank their cash out. And without deposits, banks can’t sell loans.

What all that means is that when the stock price collapses – for any reason – it can actually drive a bank to the wall.

Now, regulators are supposed to put measures in place to give people confidence that their deposits are safe and sound. But the crisis has shown that regulators can’t “future-proof” everything, and when it comes to money, people tend to shoot first and ask questions second. It’s why confidence – of depositors, borrowers, and shareholders alike – is so important.

2. The cost to insure every dollar

One way to make sure confidence is fully restored, according to banking analysts, is for the Federal Deposit Insurance Corporation (FDIC) to insure every US dollar deposited in the system. Do that, and there’d be no need for anyone to panic and withdraw their funds. And, sure, that might work if no one thinks too much about it. But take a look at the following chart, which shows the total deposits in the US (light blue line) plotted against the Federal Reserve’s (the Fed’s) total assets (dark blue). At around $19 trillion, US deposits are roughly 73% of America’s total economy and more than two times the Fed’s current balance sheet. It seems a tad unrealistic to think the Fed or the US government would cover that tab.

Total deposits in the US (light blue line) plotted against the Fed’s total assets (dark blue). Source: Goldman Sachs.

Of course, it’s highly unlikely that every person and business in the US would withdraw their cash at the same time and stuff it under the mattress. Most cash that comes out of one bank just goes into another. But an insurance policy is valid only if there are enough funds to cover its claims – that’s how insurance works. Most insurance firms – believe it or not – actually pay out more in claims than they take in premiums. So, maybe this is nagging at me more than it’s nagging at policymakers or other investors – but perhaps it’s the sheer unaffordability of it all that’s stopping authorities from approving universal, no-maximum deposit insurance.

3. The sheer size of it all

The common narrative is that JPMorgan (JPM) and its big bank brethren are the ultimate beneficiaries of the regional bank fallout. And that could be true. JPM’s done well out of the crisis so far, gobbling up deposits from regional banks or buying for a song those institutions that have failed. But imagine for a second that investors lose confidence in the entire banking system (triggered perhaps by a government default). It’s a worrying puzzle: crucial institutions that are too big to fail, but also too big to save.

Now, I’m not suggesting that big banks are vulnerable and likely to collapse like their smaller counterparts – they’re subject to much stricter rules on the amount of cash they need to hold for stressed times. But just a whiff of flailing confidence in the big guys could be catastrophic. The top five US banks have over $5 trillion in deposits, and while it would be inconceivable to let the big banks fail, the vast sums involved in propping them up would mean even more debt on the government’s already bloated balance sheet or some serious inflation-inducing cash injections from the Fed. And both of these would pose some seriously negative, inflationary side effects.

What’s this mean for your portfolio?

Authorities could still pull a rabbit out of the hat and come up with a creative confidence-restoring solution for these regional banks. But there are some tough issues still to be resolved, and that might mean regulators cross their fingers and hope the turbulence just blows over. And that might actually happen too: every passing day without a full-blown crisis is a day closer to confidence being restored.

But the current turmoil will cast a long shadow, and it’ll likely mean much more regulation in the future – a poor backdrop for bank investing. Keep in mind too that no bank – not even JPMorgan – has outperformed the S&P 500 over the past five years. It comes down to this: banks struggle to make money with low interest rates, and yet higher rates (at least this time) have sparked a crisis and multiple failures. That feels like “heads you lose, tails you don’t win” to me. Banking sector investing is hard and, in my opinion, should mostly be body-swerved.

But I wouldn’t go as far as betting against banks either, by, say, shorting or buying “put” options that allow you to profit when stocks fall. The risk of a creative regulatory solution to the crisis sparking a surge in bank stocks is too high for that. Instead, you could focus your efforts on seeking out firms whose futures are not determined by regulatory influence or unpredictable macroeconomic conditions. Consider the iShares S&P 500 Consumer Staples Sector ETF (ticker: IUCS; expense ratio: 0.15%) for broad exposure to those types of firms.

And finally, it won’t have gone unnoticed by crypto investors that bitcoin has been doing rather well of late. That’s important because one of crypto’s central attributes is its status as an alternative to the banking system. Bitcoin would likely benefit further from a worsening banking crisis.