Small banks don’t like high rates
bloomberg.com
bloomberg.com
Commercial real estate (CRE) is deeply linked to small banks in a way that's hard to understand. They often are willing to lend at lower rates, are more flexible about financing structures, payment, etc. This is the kind of non-scalable business that the big banks don't really want to touch and is an important driver of CRE activity. I have a friend who develops hotels in NYC for example and even there, a stone's throw away from wall street and HQ of the largest banks on the planet, their financing is often much easier with a small community bank that have essentially specialised in NYC CRE lending.
[1] https://www.forbes.com/advisor/investing/fed-funds-rate-hist...
(Furthermore from 1990 to 2008 the vast majority of the time the rate was well over 2.5%)
If the bank holds everything in short duration T-Bills, then rate increases don't impact them negatively in any meaningful way. Of course, the whole premise of making money via banking is to get a spread over the risk free rate.
Fixed rate debt actually creates all kinds of distortions throughout the economy. If banks held all floating rate debt, then rate increases also wouldn't matter (outside of increased credit risk) as the rate hikes get baked into the interest they accrue on the loan.
Mortgages are another example of a fixed rate distortion. You can see how frozen the market is due to all of the fixed rate debt issued far below what a non-fed intervention market price would have been. In most countries mortgages are majority floating rate, which leads to better responsiveness of price to changing conditions. In the end it will trend back to equilibrium anyway, just takes longer.
Bricks and mortar banks are slowly dying too - they're mostly used by the old, and as that generation dies, the young are preferring all-online app based banking services.
While it’s true local banks provide a public local benefit, they are IME just inefficient - tons of brick and mortar, overly reliant on upselling you on services that are frankly rip-off’s. The large physical and human presence basically means your ROI as a customer is capped due to poor unit margins. Another thing I really dislike about businesses at this scale is they are very often nepotistic. Where I’m from it’s very common for businesses to pass from generation to generation - your career is really capped if you’re not “in”. One of the nice things about huge corporations is that they’re a bit more merit-based in who they hire. Are small businesses cute and quaint, sure, but I don’t feel bad for them.
You bring your balances to that bank because you want a local bank with responsive customer service, or if they are better aware of local business conditions and better able to assess the risk of the projects they finance.
I'd wager smaller banks would, in general, be more conservative with their loans if not for commoditization.
Assuming we are talking about loans as a commodity, yes & no. They work out in the same manner as any other economic commodity which is some will outperform, some will perform, and others will under perform. Will gold work out long term, or TSLA? If I could definitively answer these questions I'd be very wealthy. The logic behind tranching makes sense and allows some shifting around of risk and some diversification.
>If you are able to take riskier loans and sell them off from an area, how long until you have nothing but high risk left that nobody will touch? And does that leave places depleted?
This scenario of "nothing but high risk left that nobody will touch," can happen both in a non-commoditized world and in a commoditized world. There will always be loans which are too risky for a bank to take. Commoditization has increased the risk ceiling so to speak. If commoditization wasn't happening wouldn't these places still be depleted, what is shifting is that ceiling of letting people in or not.
The current scenario seems to be:
* regional bank gets local depositors to get cash for lending
* regional bank can originate loans that they sell off to larger bank
* larger bank makes long term money off the intrinsics of the loan
* regional bank made short term money on sale and now has to invest in other long term assets
* regional bank loses all lending opportunities they have locally, so now survive only on long term assets and depositors
My gut is that there is no way you can spin a risk free story here. Big banks don't really solve it, either. We ultimately push that risk back to the government and some of our backstop regulations?
Edit: At least, on paper, if the depositors are local to the bank, that aligns them to the same incentives as the bank. Something SVB definitely did not have.
First, there's a bit of an assumption of local lending opportunities drying up. This isn't necessarily going to happen, local banks don't have infinite capital, but lets assume that it does happen and consider the scenario you outlined.
I think you are right in that there will be a misalignment of incentives. From the standpoint of long term assets the bank will be holding it will likely be diversified away from exposure to the town. I imagine banks wouldn't be selling off their entire portfolios, and would still have a solid amount of local exposure - but maybe not.
Banking is definitely not risk free! It is multiplying your money supply but doing so through leverage. Back to our scenario to see this effect, what "big bank world" allows there is a step that you missed:
* regional bank gets local depositors to get cash for lending
* regional bank can originate loans that they sell off to larger bank
* larger bank makes long term money off the intrinsics of the loan
* regional bank made short term money on sale and now has to invest in other long term assets
* regional bank can originate more loans with short term money on sale
* regional bank loses all lending opportunities they have locally, so now survive only on long term assets and depositors
I'm also further curious on how you think that the huge corporations are more merit-based? My gut would be that they are about the same, all told. They will have the benefit of more applicants, but they have the downside of lower risk of failure.
Where I’m from a lot of family businesses/businesses that end up becoming functionally family businesses basically only hire family into upper level positions, which often function more like sinecures. You can argue it’s their right, sure, but I think it’s bad for society. You see it all the time in real estate, local banking and financial services (esp. wealth management), law, logistics or other local blue collar businesses (even medicine - it turns out when you’re an influential local doctor it’s a lot easier to get your kid into the local medical school). That is not to say that family connections are always meritless but I think it’s a big negative of small “family owned businesses” in locking outsiders out of opportunities for social advancement.
Regarding bigger banks being better - they can afford to hire really smart people whose work scales over all their customers. They have a much more diverse customer base which reduces risk. Local banks cannot do this as efficiently due to having less customers. I also personally don’t care about the human aspect of my bank at all - they provide financial products which are usually very comparable to those at other banks, and I prefer to do everything online by myself - so I see investments in that area as unnecessary and potentially wasteful (insofar as it impacts rates/terms/etc with poorer margins).
A big downside is that they are also less incentivized to train up folks. Larger corporations seem to have decided that that can all be offloaded to "the market forces" such that they can just hire new folks that are more up on current techniques.
I don't buy them being able to better scale over their customers. At face value, it seems more that they have more managed to get society to stop giving a shit about the smaller communities that have no choice but to bank with them.
I mentioned in another comment about how most small banks closely tied to the local business environment and especially CRE markets. The difference between a single CRE developer being 5% of your portfolio when you're one tiny bank and 0.5% when you're a slightly larger bank is massive. You scale that up even more and banking gets more reliable and easier to manage the larger the banks are.
The fewer banks there are, the easier it is to provide oversight and regulate them. You have fewer institutions to coordinate when trying to push big changes, and what fewer institutions do exist are more resilient and able to absorb larger losses.
That is, sure, the bank disappears if the town does. But the question is if local banks help towns not disappear? There are tangible goods for having value pumped locally into the place that has it. Versus the larger banks that have no reason to invest in smaller towns.
The too big to fail banks are also prone to this but in theory because they are regionally diversified less so. Still without government guarantees about half or more would have failed in 2008/2010 time period. Still with government guarantees these banks have access to much cheaper capital and more liquidity when a crisis happens to they can out compete smaller banks.
And again, any systemic risk to a town seems to still exist. Just now there is nothing keeping money made on interest in the town. Literally all profits from localities are shifted out to wherever the bank is located.
There are other ways to mitigate that institutional risk. Such as FDIC insurance. And the availability of securitization for loans. The bank makes the loan, sells it off to Wall St, where it becomes part of a bond deal. And now the bank is insulated from default risk, and can make another loan.
Before securitization, when a local crash hit, lending became hard, and the downturn would stretch out. After securitization, towns began to bounce back more quickly after local hard times (eg a factory closing).
On the other hand "too big to fail" is a huge problem with the biggest banks. And regulation stops being meaningful when the institutions engage in regulatory capture. As an example, in the leadup to 2008, a ton of new financial regulations were enacted. But all benefited the same 5 Wall St firms. Who, when they ran into trouble, nearly destroyed our financial system. (I know people think it was overblown. But we were actually within 1 day of "ATMs will stop working" when TARP was passed.)
This isn't necessarily a bad thing from the perspective of the town.
And it creates a great incentive for the bank to invest back into the town. At least on paper?
> The article is kind of all over the place.
Just mentioning this because I've seen previous HN comments that are confused by Matt Levine's article style, but his posts are basically "newsletter" format, where each section is essentially an entirely different article. Not sure if you were just referring to the first section being all over the place, but the fact that the other sections are on totally different topics is just the format.
As to the rest of your comment, I wholeheartedly agree, but over the past ~25 years I've had a very strong re-evaluation that this pursuit of "optimization" over all else has some severe negative societal consequences that most people really don't like. This massive consolidation has gone on across many, many industries that the Internet has affected, and it has decimated many parts of society. E.g. it's totally valid IMO to say that before craigslist and Google that lots of small, regional newspapers charged exorbitant rates for classifieds, but now that the internet has sucked up all that money, you're left with basically no "real" local newspapers in most smaller cities, and all the money that would have stayed in that community has been vacuumed up to the Bay Area or NYC. Again, to emphasize, not saying either way is totally "right" or "wrong", but I think Levine's point is that the inefficiency of local banking brought measurable benefits to local communities.
Is there any smaller, local, customer respecting business that isn't "inefficient" in comparison to a megaconglomerate which can use monopoly and mass consolidation to operate with lower costs, worse customer experience after they achieved local monopoly?
I find large companies to be superior in nearly everything, particularly availability of online services, except exception handling. And even there, plenty of larger companies have chat support. Many smaller ones merely have the phone.
Exactly.
When something goes wrong (and it will), I want to walk into a branch and have a human being fix things.
I don't want to put my money into the Bank of Google, where customer service is only given to people with nine figure balances, and everyone else has to shout into the void of social media to get help.
Some things don't scale for good reason.
Banks have consolidated ever since.
This is the central theme of the product/platform we are working on right now. The objective is to enable small US banks the ability to automate large portions of their business, enabling cheaper employees to handle the day-to-day, reduce back office size, etc, etc.
Getting a small, 5-branch bank completely end-to-end with a digital onboarding workflow can cut the cost of bringing in new customers by 80% or better. Paperwork is what is still killing most of the small ones. Scanning/printing/reviewing/etc. Allowing the bankers to work outside the physical branches is another thing that is coming up a lot these days. Acquiring new business customers can be much easier when you are able to open accounts and answer complex questions directly inside their place of business.
The biggest strategic challenge with all of this is the cost of deploying such a solution. The tiny bank in Nowhere, TX can't afford super shiny & expensive software/consulting/etc. We had to figure out how to squeeze a digital transformation into a low 6 figure package and do it with only a handful of people. This is the real hard shit. Saving the small banks while still getting paid enough to do it. I think this is why you see this massive gulf between Ally.com and the 1 branch specials that were created in the 1800s. The cost of the transformation itself is the barrier. Once you are across the line it's cheap.
In terms of consolidation, we've seen the effects of good technology on our clients. It turns them from prey into predator pretty quickly. Every one of the small banks who has used our solution has acquired additional branches over time.
My experience has been exactly the opposite.
My experience with Wells Fargo, a big bank was constant up-selling and fees. Back when it was still legal Wells Fargo would send me these fake checks that if you cashed were effectively a loan.... Constant hassling / offers that were WAY off from market rates.
My experience with small banks was nothing like that and far more positive, better rates, etc.
Just because someone's margins are different or worse than someone else doesn't mean they inevitably choose to make up the difference, or if they do if they do it with poor choices.
Usually only bank and other primary dealers can have an account at the Fed but the reverse repo facility allows money markets (and thus anyone) to basically passthrough to the Fed.
Given the high interest yield offered and the fact that the Fed by definition cannot go bust, there is no reason to put your money at a small bank due to the risk and low reward.
The problem right now is that those small banks' balance sheets are being squeezed by the pace of raising interest rates.
Largest banks have unprecedented regional networks and perceived as vert safe so they can allow themself to pay shit rates on deposits and use it to give out mortgages. Principal business plan of regional banks is undercut. The only way how they may stay alive is to ally with large regional businesses to be used as their purse.
Add to that is that modern bank is an IT company and a large bank may invest in much more sophisticated online services.
And as the largest retail banks offer zero interest, it doesn’t quite mesh with that narrative.
https://www.jpmorgan.com/wealth-management/premium-deposit
https://olui2.fs.ml.com/Publish/Content/application/pdf/GWMO...
https://www.cit.com/cit-bank/platinum-savings
https://www.cit.com/cit-bank/bank/savings/savings-connect-ac...
CIT is a subsidiary of First Citizens, which is 19th on the list of US banks on Wikipedia.
The point is that large banks have a win-win right now - higher rates make it easier for them to make money, but the fact that people were spooked by regional bank failures means that they don't need to turn around and offer higher rates to attract deposits.
First republic had a moment where bigger banks deposited ~$30B into it, but even that was a small percentage of their overall depositor base. As deposits continued to flee they had to rely more on the fed (and then failed).
If the socially beneficial aspects of local banking are funded by the spread between what the bank pays its customers and the market rate of interest (in the Federal Funds Rate/the 4 week t-bill/money market fund yields/etc) why does the spread have to be so high? Why can't the bank pay its depositors 3% and do this stuff with a 2% spread?
A 5% spread is the highest in at least 15 years and local banks seemed to be doing fine throughout much of that period.
https://www.bankrate.com/banking/federal-reserve/federal-res...
Most people just need an account that keeps track of their ins and outs, and there is no reason it could not be government operated.
Of course, with a constitutional amendment that every person has a right to an electronic money account with the ability to send and receive money at all times, regardless of convictions or whatever. And the government is obligated to provide identity verification services.
“You could have […] a potentially better — or some people might say a darker world — where the government decides that units of central bank money can be used to purchase some things, but not other things that it deems less desirable like say ammunition, or drugs, or pornography, or something of the sort, and that is very powerful in terms of the use of a CBDC, and I think also extremely dangerous to central banks.”
“Now we are at the cusp of physical currency essentially disappearing”
Eswar Prasad, WEF Annual Meeting of the New Champions, June 2023
https://sociable.co/government-and-policy/governments-progra...