Less Banks & More Banks

The banking squeeze is on. It’s no secret that 2023 has been a very challenging year for banks – especially mid-sized and super regional ones.

The collapse of Silicon Valley Bank, First Republic, and Signature Bank has spooked depositors into thinking that their money may not be safe at smaller banks. It also appeared that deposits would jump ship to mega cap banks that are too big to fail (Bank of America, JPMorgan, Wells Fargo, etc.)

While the too big to fail banks have seen an influx of deposits, the flight from regional banks has yet to happen. That doesn’t mean regional banks are safe yet.

First – there appears to be increased regulations coming for mid-sized banks, which may limit their lending activity and increase compliance costs. But that’s a conversation for a different day.

I want to focus this article on why increased interest rate environments will cause bank consolidation and why more niche banks will come to life as a result.

Deposits are so important for banks

It’s important to remember just how important deposits are to banks.

At their core, banks take in customer deposits and use those deposits to make loans.

Loans are assets that can be sold or used to generate cash from interest.

In higher interest rate environments, deposits become more expensive to the bank as customers demand the bank to pay them interest on their cash. For example, if a person (or business) can earn 5% on a money market account vs. 0% on a checking account, they will move the cash to the money market and earn a higher yield. Therefore, banks will offer higher-yielding accounts to deter customers from moving cash to another institution.

This dynamic leads to a bidding war amongst banks for deposits, with some institutions knowingly taking a loss on deposits to ensure the customer stays. Note: most banks, I believe, elect to stay “competitive enough” – offering yields high enough that the customer doesn’t want to deal with the headache of moving cash around.

However, this game gets more painful with every move higher in interest rates.

Imagine a regional bank that made 3% fixed mortgages in 2020-2022, but now has to pay customers 5% on deposits. They are earning less than what they are paying.

Ultimately flipping the business model upside down.

Enter stressed-out bankers

When interest rates go up, deposits get more expensive, and demand for loans go down.

Banks will look to other services (e.g. Wealth Management) to generate revenue.

But most of these community banks don’t have the adjacent services to cover the eroding profit margins. Traditionally, they could charge fees for premium accounts and relationship managers. However, customers are used to being offered “free” accounts and there’s a plethora of institutions that offer such a deal, and with low switching costs, it would be a bold move for a bank to charge a monthly fee. Additionally, relationship managers are expensive and don’t scale well. So we find ourselves in a situation where smaller banks:

•  Are paying more for deposits

•  Demand for loans going down

•  Don’t have wide set of services to compete

•  Customers fear for the safety of their accounts

In such instances, the “too big to fail” banks can swoop in, acquire the stressed mid-size banks and save the day. These too big to fail banks have the resources, business models, and scale to absorb the stressed mid-size banks and make them profitable.

This situation checks all the boxes:

• Bigger banks can afford to pay out on deposits

• Lower loan demand won’t have an outsized impact

• They have a variety of different services to cover losses

• As a too big to fail bank, the government guarantees deposits

The big banks will balloon in size, these elephant sized institutions will become mammoths and even though it solves some of the current problems, this model will have negative impacts too.

The mammoth-sized banks will have to focus on larger-sized customers and deals to move the needle. Bankers will therefore lose focus on small to medium-sized businesses and niche customers while prioritizing the big guys. This will cause some pain down the food chain.

Enter the flees

With less banking options available and a focus on larger customers, newer, smaller banks will arise that specialize in niche customer profiles.

We’ll call them “flees” as they will be so small compared to the mammoth.

These “flees” won’t be traditional banks, they will be neobanks. Neobanks can sprout up pretty fast, circumventing the traditional bank start-up or “de novo” process. These neobank flees will be experts in niche markets, tailoring products and services to customers that are overlooked by mammoths, that those customers would happily pay monthly fees and other premiums to bank with them.

While flees may not be scary to a mammoth, they can be pesky. The pesky flee must be watched because if not it will grow louder and peskier over time.

For my next post, I will dive deeper into these pesky flees, what is a neobank, and how they can bite off-market share over time.