Breaking the doom loop for U.S. banks

With the U.S. banking sector facing a “doom loop,” it’s time to bring back a financial crisis–era emergency backstop to shore up confidence, argues DBRS Morningstar.

In a new report, the firm indicated that U.S. banks are facing a self-reinforcing spiral as scared investors dump bank stocks amid fears of further bank runs and failures, despite the banks generally enjoying strong earnings and sound asset quality. In turn, the negative market sentiment threatens to undermine banks’ strong fundamentals.

“The doom loop occurs when sharply lower stock prices worry depositors causing them to rapidly withdraw large sums of deposits that are typically lower-cost funding sources for banks,” the report said. “This in turn forces banks to borrow funds at much higher rates to backstop any funding shortfalls, adversely impacting their net interest margins and overall profitability.”

“The more a stock declines, the more likely a depositor will withdraw deposits, particularly uninsured depositors, reinforcing the doom loop,” DBRS said.

These forces have generally benefited the largest banks, which are perceived as safer and unlikely to be allowed to fail, it noted — enabling them to draw deposits away from the shakier small and mid-sized banks.

To break the doom loop, the report suggested that regulators revive a relic of the 2008 financial crisis: the Transaction Account Guarantee Program. The program allowed banks to fully insure “all domestic non-interest-bearing transaction deposits, low-interest NOW [negotiable order of withdrawal] accounts and Interest on Lawyer Trust Accounts,” it said.

“In our view, this would help diminish the market-perceived safety advantage for the [big banks] while sustaining competition from smaller U.S. banks,” it said.

Longer term, policy-makers will have to pursue reforms to address the lessons of the recent turmoil in the banking sector.

“Regulators are working to enhance regulation and address the added pitfalls of being in a digital world (impact of social media sparking deposit runs, as well as the ease of moving deposits electronically), but these efforts will take time, as well as the cooperation of an increasingly polarized Congress,” DBRS said.

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.