Crowding Out: Banks vs. Cash Management With Whole Life
The recent banking crisis has been well covered by many at this point. Bank failures have exposed fragility within the fiat-based, fractional reserve banking system, which has savers and investors anxiously exploring their options. Increased U.S. government deficit spending, along with regulation, may be “crowding out” the private sector, in which business owners (especially small business owners) and real estate investors may see their traditional financing options become more costly or even disappear. We hope to clearly convey our thoughts below, while providing an alternative solution should our thesis unfortunately play out as expected.
Government Stimulus & Inflation
We now know that the recent bank failures were largely caused by an asset-liability mismatch. However, it’s a bit more complicated. We first need to back up to 2020 when the Covid-19 stimulus first started. As Jeff Deist noted, Congress’ two stimulus bills pumped more than $5 trillion into the economy in the form of government payments, household payments, unemployment benefits, payroll loans, etc. A casual observer may see some consequences arising from forcing hundreds of thousands of businesses to close while simultaneously printing over 20% of all dollars ever created into existence. One might be inclined to believe that more dollars chasing fewer goods and services leads to higher consumer prices.
However, need not worry, said the Federal Reserve. In his Jackson Hole speech from 2020, Fed Chair Jerome Powell remarked, “Many find it counterintuitive that the Fed would want to push up inflation… However, inflation that is persistently too low can pose serious risks to the economy.” In order to keep rates down and generate aggregate demand, the Federal Reserve went on to purchase trillions of dollars of long-term U.S. Treasury securities (USTs) and agency mortgage backed securities (MBS) at decade-low yields, or decade-high prices. Banks, now flush with deposits as the $5T in freshly printed stimulus worked its way through the economy, followed suit in buying the same securities at similar prices, heeding the Fed’s guidance that inflation would remain low and interest rates would stay near zero for several years.
We all know how the story plays out from here. The Fed was caught off guard and consumer price inflation surged in 2021 and 2022. Everyone then demanded the Fed “do something.” As a result, the Fed raised rates from 0% to 5% within about 18 months, marking one of the most aggressive tightening periods in U.S. history. Many banks, expecting rates to remain low, watched their fixed-income assets plummet in value. Now that short-term rates (bank funding costs) have increased, net interest margins have collapsed, reducing bank profitability. Therefore, these banks are limited on how high they can take deposit rates while remaining profitable. As savers flee for higher-yielding options, these banks are ill-equipped to maintain lending growth.
Another way of thinking about rate hikes is that the Federal Reserve was, and still is, paying banks and consumers not to lend. Historically, this worked well to curb inflation as private sector credit would contract. However, the 2020 stimulus resulted in a massive increase in U.S. government debt, and as a result, banks increased holdings of U.S. Treasury and agency securities (government debt) relative to commercial and industrial loans, which is a proxy for private sector loan activity. Since the U.S. government continues to spend at a rapid pace, rate hikes haven’t been as effective as historical attempts to reduce total spending and consumption.
When you consider that each 1% increase in rates increases the U.S. deficit by $320B from the increased interest expense, it seems as though the Fed is replacing private sector credit with government debt. Additionally, now that foreigners are reducing U.S. Treasury holdings alongside the Federal Reserve, the U.S. private sector remains the lone marginal buyer.
Bank Regulation & Asset Allocation
You may be thinking that the U.S. government consistently racks up more debt as deficits climb, and therefore, it’s counterintuitive that an institution’s cost of capital (interest rates) would decrease as profitability declines. Investors who avoided buying these securities at ultra-low rates knew something had to give. Either inflation would run hot wiping away the real returns or interest rates would increase, reducing the market value of assets while potentially threatening the solvency of the government. So, why were banks increasing their holdings in U.S. government debt?
One reason is regulation. The largest banks (primarily >$250B in assets) are subject to a liquidity rule called the liquidity coverage ratio (LCR), which requires them to hold sufficient high-quality liquid assets (HQLA) in order to meet heavy redemptions during market stress. HQLA are generally defined as USTs, agency securities, and agency MBS. As reserves decline and U.S. government debt increases, regulation requires the largest banks to maintain holdings of U.S. Treasuries, which reduces the capacity for corporate lending. It’s quite plausible that this regulation is crowding out the private sector, and therefore, it’s no surprise that banks are tightening credit standards.
Lastly, many of these banks are deemed “too big to fail,” which is perhaps why you may have seen heavy flows from smaller regional banks to some of the largest banks earlier this year. Therefore, not only do we have banks reducing lending to the private sector, but deposits have also flowed from smaller banks ($250B or less in assets) to the largest banks. This is especially concerning for small businesses since the smaller banks account for about 70% of all small business loans and 80% of commercial real estate loans.
This is also problematic for savers who may feel their options are limited to keeping cash at risky smaller banks as deposits are pulled, exposing them to solvency risk, or keeping cash at the largest banks that may be “too big to fail” but refuse to pay attractive rates on deposits. One last option may be money market funds which also invest in USTs, putting lots of faith into just one issuer — the U.S. Government — who just narrowly avoided default. Aside from carrying U.S. government credit risk, those interest rates are not guaranteed, and any interest is taxable.
Banks vs. Life Insurers
Banks are in a precarious position. Regulation is pushing them to fund the U.S. government, and while many claim these USTs are the safest and most liquid securities in the world, investors saw the market value of their holdings fall by up to nearly 30% last year as inflation surged and interest rates increased. Furthermore, since U.S. government expenditures frequently preclude any required rate of return calculations, an increase in government debt is unlikely to increase tax receipts (government profit), which is likely to result in increased government default risk. USTs have significant inflation, interest-rate and credit risk.
Alternatively, while corporate bonds performed poorly in 2022 as rates increased, corporate credit risk declined for many companies as profitability increased since the issuers were able to pass through higher costs to customers. Insurers are the largest buyers of corporate bonds, and they hold relatively few USTs. In fact, the NAIC showed that just 2.7% of all life insurer assets were USTs. The remainder of assets were corporate bonds, mortgages, muni bonds, common stocks, bank loans, etc. Since life insurers focus on investing in companies that generate sufficient real returns to cover death benefits, perhaps this explains their tremendous resilience compared to banks over the past 100+ years.
Alternative Solution
Savers may be thinking twice about storing money at a conventional bank or in other instruments that invest heavily in the U.S. government and fail to generate attractive returns. Continued growth in U.S. government debt is likely to crowd out the private sector, reducing financing options for small business owners, or may result in heavy inflation, which could put your capital at risk as banks struggle with higher interest rates.
If you’re interested in generating tax-advantaged, guaranteed returns in a vehicle that allows you to continuously compound capital, a properly structured whole life insurance policy may be for you. Cash management with whole life insurance provides savers and investors with full control of their capital, thereby reducing reliance on external financing. Please contact infineo to learn more.
Email: chad.holstlaw@infineo.io
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