Part 2: Another Banking Fail

"When written in Chinese, the word crisis is composed of two characters -- one represents danger, and the other represents opportunity." John F. Kennedy

In an earlier post, we discussed strategy as a metronome, ticking back and forth between extremes but always returning to the center. It's been eight weeks since Silicon Valley Bank's (SVB) collapse and eight hours (as of this writing) since First Republic Bank's (FRC) takeover. We did not believe that SVB would be an isolated incident. Their two-part strategy, providing long-term, below-market-rate loans to wealthy people in exchange for their deposits, then reinvesting those deposits in long-term, low-interest bonds, was unsustainable. As interest rates rose, the loans and bonds lost value, and banks faced record losses.

The critical question remains: is there another shoe to drop? Or does the trend reverse and stability prevail? The challenge with a metronome is identifying the inflection point. Our experience tells us that the effect of a decade of artificially suppressed interest rates will not resolve itself in two months. What should you expect if you are a CFO whose company needs access to credit?

First, rates will stay higher for longer. Banks will shift from growing their credit portfolio to ensuring they add accretive loans. Subsidized loans are a thing of the past. Collateral requirements supporting new credit will increase. With diminished access to capital, the number of new projects will decline, which is the government's intention as it looks to slow inflation by reducing demand. We see little exception to this path forward.

Second, CFOs must revisit the assumptions underpinning new investments. We continue to see executives justifying investments based on unsustainable revenue projections. A bit of conservatism is justified. Adjusting hurdle rates beyond linear projections of future hurdle rates is required to account for flat to slightly decreased demand. If conditions improve and returns exceed projections, that is better than the alternative.

Finally, increased government regulation of banking operations and lending activities is a given. However, we know regulations are a lagging indicator, and only at this point would we feel comfortable defining the path forward. Expect the usual tools to be employed, more detailed disclosures, caps on the level of non-core activities, and greater financial accountability for management and investors. These actions will reign in credit in the medium term and constrain growth.

Once growth slows and increased regulations are defined, executives can plan a path forward. In the meantime, we suggest reexamining the return expectations of projects and mapping out declining demand scenarios. Ultimately, we expect the noise around bank failures to decline; however, the pain is not over. Smaller regional banks will continue to face pressure as megabanks gain market share and use their size to weather the storm. Only when we move into the second and third-order effects, such as limited growth due to constrained credit and increased government regulation, can executives breathe a sigh of relief and begin moving forward.