“The 2023 banking crisis is not over as long as there are banks with Deception Ratios over 100%. The Fed solved the bank liquidity problem without addressing the bank solvency problem.”
Three banks failed last month: Silvergate Bank on March 8, Silicon Valley Bank on March 10, and Signature Bank on March 12. A fourth bank (First Republic Bank) was over $9 billion underwater and had to be propped up with $30 billion in emergency loans from 11 other banks, and the stock is still down over 88% from just one month ago.
In response, the Fed created the Bank Term Funding Program (BFTP) which provides emergency loans to banks so that they can repay depositors on demand without running into a liquidity problem. However, the interest rate on those loans is something called the “1-year overnight index swap rate” plus 0.1%. As of today, that’s about 5%. However, many banks are holding portfolios of debt securities that are only yielding about 2%. For example, here are the average portfolio yields for 3 randomly selected publicly-traded banks:
| Bank | Average Yield of Debt Securities Portfolio (as of Dec 31, 2022) |
| Mercantile Bank (NASDAQ: MBWM) | 1.72% |
| Byline Bancorp (NYSE: BY) | 1.89% |
| PacWest Bancorp (PACW) | 2.36% |
That means banks which borrow BFTP money from the Fed are borrowing money at a high interest rate just to lend it out at a much lower interest rate. For example, on March 22, PacWest announced it had borrowed $2.1 billion through BFTP at around 5%. However, the table above shows that PacWest only earns 2.36% from its debt securities. The net effect of the BFTP loan on PacWest’s balance sheet is the same as if PacWest had $2.1 billion of assets earning 2.36% evaporate and be replaced by $2.1 billion of liabilities costing 2.64%. Or, said another way, it instantly wiped out $4.2 billion of stockholders’ equity.
In reality, that $4.2 billion of stockholders’ equity was already gone. It was just being hidden from the balance sheet through the deceptive accounting tricks used by banks. Since the balance sheet from the bank’s 2022 annual report only claimed $3.95 billion of total stockholder’s equity, that means PacWest is almost certainly insolvent now (i.e. it has negative stockholders’ equity). And PacWest isn’t the only bank with this problem.
How much loss is the typical bank hiding off balance sheet?
We can use the statistical rule of 5 to estimate how close the typical U.S. bank is to insolvency. The result of this estimate will be a 97% confidence interval for the median unreported bank loss.
To do this, I randomly sampled 5 banks from the set of 292 commercial banks that are publicly traded on the NYSE or NASDAQ. For each bank, I calculated the percentage by which the balance sheet (BS) value of total stockholders’ equity differed from the fair value (FV) of total stockholders’ equity. I call this metric the “Bank Deception Ratio”.
The Bank Deception Ratio for each of the 5 randomly selected banks is shown in the table below.
| Bank | Bank Deception Ratio (as of Dec 31, 2022) |
| First Interstate BancSystem (NASDAQ: FIBK) | 21.5% |
| NBT Bancorp (NASDAQ: NBTB) | 24.6% |
| Washington Trust Bancorp (NASDAQ: WASH) | 33.5% |
| Guaranty Bancshares (NYSE: GNTY) | 53.7% |
| Parke Bancorp (NASDAQ: PKBK) | 24.9% |
The rule of 5 says that there is a 97% probability that the median Bank Deception Ratio of all public banks is at least 21.5%. In other words, it is almost certain that the majority of banks have have less than 79% of the equity they claim to have. In addition, statistics tells us that while it is almost certain that banks are hiding equity losses of at least 21.5%, it’s most likely that 50% of banks are hiding losses of at least 33.5% of their equity. That means half of all banks have lost more than a third of their total stockholders’ equity.
What does that mean?
Banks face two kinds of existential threats:
- Liquidity crises
- Insolvency crises
In a liquidity crisis, a bank has assets worth more than its liabilities, but its assets take a long time to sell which can put the bank into a bind if its creditors (e.g. depositors) demand their money back sooner than expected. A liquidity crisis can be solved by someone (such as the Fed) giving the bank an emergency loan to pay back creditors until the bank can finally sell some assets and pay back the loan.
A solvency crisis is completely different. In a solvency crisis, a bank has more debt (i.e. liabilities) than it has assets. In that situation, it doesn’t matter whether the bank’s assets are easy to sell or not because even if the bank could magically sell them all immediately for fair market value, the resulting cash received would not be enough to pay back all the bank’s debt.
The Fed’s Bank Term Funding Program is an emergency lending program which means it can help banks avoid liquidity crises, but it does nothing to help banks avoid insolvency crises. The math we did earlier showed that 50% of banks have probably lost over a third of their equity already. From the 8 randomly sampled banks mentioned previously in this article, we also saw one (PacWest) which likely has negative equity and one (Guaranty Bancshares) which had already lost over half of its equity as of December 31, 2022. That means dozens if not hundreds of the more than 4,000 commercial banks in the U.S. may be secretly insolvent already. And there are only two realistic ways that such zombie banks can avoid collapsing:
- The zombie bank might be acquired by a larger, better capitalized bank before the zombie bank collapses.
- The Fed may cut interest rates back down to 3% or lower within the next year or two
The first scenario is a possibility since even an insolvent bank can sometimes carry enough intangible brand value to make it worth acquiring. However, there are numerous political, legal, and practical obstacles to such acquisitions that must all be overcome to make those deals happen.
The second scenario is also a possibility but definitely not a guarantee. Inflation is still high, OPEC+ unexpectedly announced oil production cuts yesterday, global supply chains are being reworked into slightly less efficient national supply chains, and the Ukraine war is still ongoing. In other words, inflation is high and may well remain high for years to come. If it does, the Fed may not be able to cut rates enough to make zombie banks solvent again.
Carpe diem, short sellers.
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Which banks are in danger of failing?
Most of the 4,000+ commercial banks in the U.S. are not publicly traded companies which means we don’t have access to their financial statements. That makes it impossible to know how high the risk is of those banks collapsing.
However, for publicly traded banks, we can look at SEC filings. If you want to know how high the danger is of any particular public bank failing, search the name of the bank using EDGAR and find the most recent form 10-K or 10-Q. Once you find the form, follow the steps in this article (balance sheet lie #1) to calculate the fair value adjusted stockholders’ equity. You can then calculate the Bank Deception Ratio using the formula provided earlier in this article. If the Bank Deception Ratio is over 50%, then the bank is at pretty high risk of failing.
Do bank failures create any business opportunities?
Bank failures create opportunities for sophisticated investors:
- Shorting bank stocks which are at higher risk of failure than the stock market realizes
- Shorting the stock of companies with large uninsured deposits at non-systemically-important banks that are at high risk of failure
- Shorting the stock of fintech companies who rely on key partner banks that are at high risk of failure
References
[1] First Interstate BancSystem (FIBK) annual report for 2022
| Balance Sheet Value | Fair Value | BS-FV Discrepancy | |
| Total Assets | $32.288 Billion | $31.568 Billion | -2.2% |
| Total Liabilities | $29.214 Billion | $29.150 Billion | 0.0% |
| Total Stockholders’ Equity | $3.079 Billion | $2.418 Billion | -21.5% |
[2] NBT Bancorp (NBTB) annual report for 2022
| Balance Sheet Value | Fair Value | BS-FV Discrepancy | |
| Total Assets | $11.739 Billion | $11.423 Billion | -2.7% |
| Total Liabilities | $10.566 Billion | $10.538 Billion | -0.3% |
| Total Stockholders’ Equity | $1.174 Billion | $885 Million | -24.6% |
[3] Washington Trust Bancorp (WASH) annual report for 2022
| Balance Sheet Value | Fair Value | BS-FV Discrepancy | |
| Total Assets | $6.660 Billion | $6.517 Billion | -2.1% |
| Total Liabilities | $6.206 Billion | $6.216 Billion | +0.1% |
| Total Stockholders’ Equity | $454 Million | $302 Million | -33.5% |
[4] Guaranty Bancshares (GNTY) annual report for 2022
| Balance Sheet Value | Fair Value | BS-FV Discrepancy | |
| Total Assets | $3.351 Billion | $3.191 Billion | -4.8% |
| Total Liabilities | $3.056 Billion | $3.054 Billion | -0.1% |
| Total Stockholders’ Equity | $296 Million | $137 Million | -53.7% |
[5] Parke Bancorp (PKBK) annual report for 2022
| Balance Sheet Value | Fair Value | BS-FV Discrepancy | |
| Total Assets | $1.985 Billion | $1.926 Billion | -3.0% |
| Total Liabilities | $1.719 Billion | $1.726 Billion | 0.0% |
| Total Stockholders’ Equity | $266 Million | $200 Million | -24.9% |