Bank Fragility 2.0
The S&P 500 finished the first quarter up 7.5%. Unlike 2022, large technology-oriented companies led the advance as the median stock appreciated a little more than 1%. The markets started the year strong as expectations for a Federal Reserve rate cut at the end of the year grew. This optimism receded as the labor market proved resilient and inflation did not cool as quickly as hoped. In our previous investment commentary, we noted that nothing major had been broken during the current market stress caused by inflation and rising interest rates. That benign circumstance changed in early March when Silicon Valley Bank failed within two days. The market gave up nearly all its gains during this time, before recovering over the last three weeks of March.
The susceptibility of banks to panics associated with credit quality concerns or interest rate movements is one of the most significant risks to financial stability. When interest rates rise quickly, it can have a cascading effect on the entire financial system, as banks struggle to manage their balance sheets, and investors and borrowers react to the changing economic environment.
Banks only maintain a small percent of their deposits in cash for immediate withdrawal. Banks are financial intermediaries that take deposits from customers and use the funds to lend to borrowers. By accepting deposits and making loans, banks play a crucial role in the economy by facilitating the flow of funds from savers to borrowers.
One way banks make money is by lending to individuals and businesses at a higher interest rate than the rate they pay on deposits. For example, a bank might pay 0.5% interest on a savings account, but charge 5% interest on a mortgage loan. Banks also make money by charging various fees, such as overdraft fees, account maintenance fees, and transaction fees. These fees can generate significant revenue for banks, especially for customers who frequently use their accounts for transactions.
In addition to traditional lending, banks also make money by investing in financial markets. Banks can invest in various financial instruments, such as stocks, bonds, and other securities, which can generate income through dividends, interest, and capital gains. Banks may also engage in proprietary trading, where they use their own funds to buy and sell securities with the aim of generating profits. While investing can be a source of income for banks, it also involves risk, and banks must carefully manage their portfolios.
The current banking stress started with a run on Silicon Valley Bank (SVB) once depositors became aware of the losses in the value of its long-dated treasury and mortgage-backed investments due to rising rates. Bank runs, where large numbers of depositors withdraw their funds from a bank due to concerns about its solvency, can happen much faster in recent times than in the past. One reason for this instability is the increased use of technology, which allows customers to access their accounts and withdraw funds more quickly and easily than ever before and from anywhere at any time. This means that news about a bank’s financial troubles can spread rapidly, causing depositors to panic and withdraw their funds en masse.
Another factor that contributes to the speed of bank runs is the interconnectedness of the global financial system. Banks are no longer isolated entities that operate within a single jurisdiction; they are part of a complex network of financial institutions that are linked through various channels. This means that problems at one bank can quickly spread to other banks, creating a domino effect that can lead to widespread panic and financial instability.
The failure of Silicon Valley Bank led to the immediate collapse of Signature Bank along with the slower decline of First Republic Bank. Problems in the US soon spread to Europe causing Switzerland to backstop UBS’s acquisition of Credit Suisse. Credit Suisse had been on life support for decades until the recent run forced the company’s dissolution.
After the Great Financial Crisis, Congress enacted Dodd Frank to prevent the problems that sparked the panic of 2007-2009. Most of the regulatory energy was focused on maintaining asset quality (since that crisis involved banks holding low-quality mortgages) and stress tests. Regardless, this framework did not avoid Silicon Valley’s bankruptcy even though the bank held treasuries and other safe investments. We believe efforts would be better spent trying to limit contagions since institutions will always run into trouble. On average, FDIC insurance covers less than half of deposits, and in SVB’s case, insurance only covered about 10%, with the remaining deposits uninsured. While the current framework and FDIC insurance protected the banking system from the 1930s until 2007, the banking system has changed enough over time that this model no longer works.
A new regulatory framework is especially important now given the increased potential for moral hazard in the financial system. Moral hazard is a term used to describe the tendency of individuals or institutions to take on more risk than they would otherwise because they believe that they will be protected from the consequences of their actions. In the context of the banking system, the concept of moral hazard is particularly relevant because banks are more likely to engage in risky behavior if they believe that they will be bailed out by the government in the event of a crisis. Bankers continue to be handsomely rewarded for taking risks in the market, but protected from ruin by bailouts and guarantees.
Problems in the banking sector will most likely impact the broader economy. Earlier in the year, it looked as though the economy might have been able to avoid a recession since the job market was so strong. However, banks (and regulators) will now most likely increase their lending standards to protect the quality of their assets. This vigilance increases the likelihood of recession since tighter lending limits commercial activity throughout the economy.
Advances in Artificial Intelligence – Future Benefits and Risks
The recent rapid advances in artificial intelligence (AI) can be attributed to several factors. One of the primary drivers has been the availability of large amounts of data, which has enabled researchers to develop more sophisticated algorithms and models. Additionally, the development of faster and more powerful computing hardware has made it possible to process and analyze this data more quickly and efficiently.
One notable recent development in the field of AI is the release of ChatGPT 3.5 and 4, which are large language models (LLM) created by OpenAI. These models can generate human-like text and have numerous potential applications, including chatbots, language translation, coding and content creation.
Artificial intelligence (AI) has the potential to significantly increase the productivity of knowledge workers in various industries. With AI-powered tools and platforms, knowledge workers can automate repetitive and time-consuming tasks, allowing them to focus on higher-level tasks that require critical thinking and decision-making. This can lead to increased efficiency, faster decision-making, and improved outcomes.
For example, in the field of medicine, AI has the potential to revolutionize patient care. AI-powered tools can be used to analyze large amounts of medical data, including patient histories, lab results, and imaging studies, to identify patterns and insights that might not be apparent to human clinicians. This can lead to faster and more accurate diagnoses, personalized treatment plans, and improved patient outcomes. Additionally, AI can be used to streamline administrative tasks such as appointment scheduling and medical record-keeping.
Despite the significant progress that has been made in AI, there are still challenges to overcome. LLMs are systems which learn by analyzing enormous amounts of digital text culled from the internet, including books, chat logs, Wikipedia articles and other information posted on the internet. The obvious problem becomes the information on the internet- there is no ombudsman of the internet to ensure its quality. LLMs may be considered AI, but the “intelligence” doesn’t include the ability to separate the bad information from the good information. And given the speed at which LLMs can create new content, bad information could quickly spread creating an echo chamber of misinformation.
AI systems can also be used for malicious purposes. Phishing emails, often written by non-English speakers, could improve with the help of an AI bot. AI bots can also help write computer code, which means the bots can also help hackers write computer viruses. Generative AI can create realistic images, leading to the false images of important people in compromising positions. Artificial Intelligence is now widely available for public use. The challenge going forward will be putting it to good use.
Our Financial Planning Process: Insurance Assessment
Managing risk is a significant aspect of wealth management. In order to maintain their financial stability, our clients have broad risk mitigation needs that expand beyond the investment solutions we offer. Therefore, we have designed our comprehensive financial planning process to include analysis of our client’s risk and insurance needs. We analyze their existing insurance and annuity products to identify potential gaps in their planning and to understand their various coverage options. We also provide advice to help clients navigate the complex insurance marketplace, so they secure sufficient and cost-effective coverage. Insurance enhances predictability and adds security to a person’s financial plan.
Life insurance is a contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money upon the death of an insured person. Most often, life insurance is used to protect a person’s family from financial hardship in the event of that person’s death. In most cases, the death benefit of a life insurance policy is income tax-free for the beneficiary. In a financial plan, we can estimate how much life insurance death benefit a person needs by either determining the coverage necessary to replace their lost income, or by calculating the cost for their survivors to maintain their desired standard of living.
In a life insurance gap analysis, first, we identify the needs of the survivors, such as covering funeral costs, paying off existing liabilities, calculating annual living expenses and taxes, or funding an education goal. Then, we review the survivor’s resources, such as income, available investment assets, and death benefits from existing policies. We utilize this information to determine if additional life insurance coverage is necessary, and if so what type of product may best fit their needs i.e., Term Insurance vs Permanent Insurance. Permanent insurance policies (whole life, universal life, or variable life) can include a cash value component that grows on a tax-deferred basis and can increase in value over time. These policies are typically much more expensive than term insurance, which provides the death benefit protection for a set number of years and no cash value element.
We perform a similar exercise when analyzing a client’s need for disability insurance. Disability insurance provides a benefit to a family when the primary income provider is unable to work because of injury or illness. Disability insurance is often overlooked as the average working individual generally relies on their employer-provided disability. However, individual long-term disability insurance can be used to supplement employer coverage or provide coverage to those who don’t have access to an employer plan. Benefits paid by these policies are tax free, and can be valuable planning tools, especially for small business owners or highly compensated individuals who earn stock options.
Recent data shows that almost 70% of people who turn 65 today will need access to some type of Long-Term Care in their life. On average, that care is needed for 3 years. Preparing for these potential health events is a vital aspect of retirement planning. Traditional Long-Term Care Insurance policies have seen rapid premium increases over the last decade plus. This has led to growth in popularity of so-called “hybrid policies”, that add a LTC benefit rider to a permanent life insurance policy like whole life or universal life. These policies offer beneficial qualities like simplified underwriting, guaranteed cash value growth rates, and favorable tax treatment. However, now that interest rates have risen, hybrid policy guaranteed growth rates look less preferable, and it may make more sense to “self-insure”. We help clients work through these decisions as a part of our financial planning analysis.
Life insurance can also help with estate planning and the management and distribution of your assets. The liquidity and tax-free status of a lump sum death benefit can be of great value when most of the deceased’s assets are in real estate or retirement accounts. For high-net-worth individuals whose heirs would face a federal estate tax burden, or who live in a state that has a state estate tax, placing an insurance policy inside an irrevocable trust can provide the funds required to pay these estate taxes. Life insurance can also assist business owners with their succession planning and provide protection to their family or business partners.
Annuities are contracts where the insurer agrees to make payments to the annuitant, either immediately or in the future, for some defined period. These contracts can be expensive and complicated to understand, but there are instances where the guaranteed income streams they provide are a good way to protect against market and/or longevity risk.
Insurance is a tradeoff where the purchaser pays the insurer to cover their risk of catastrophic financial loss due to events like death, accident, or illness. At Eagle Ridge, we do not sell any insurance or annuity products; however, we understand their value when utilized strategically. When working on a financial plan, our goal is to provide objective advice that helps our clients prioritize and achieve their financial goals. Typically, clients’ objectives for their financial plan are to save for or maintain a comfortable retirement lifestyle, purchase real estate, leave a legacy to their loved ones, fund their children or grandchildren’s educations, and protect against risks. Our aim is to provide the outline for achieving these goals while limiting income and estate taxes. We update plans as necessary for clients to help navigate various life events, milestones, and external factors. We also utilize conservative assumptions and stress test our projections so our clients can be confident in their projected outcomes.
Estimated Taxes for 2023
As 2022 tax season winds down, please keep us informed about your estimated tax liabilities for 2023. By doing so, we can ensure that there is sufficient cash distributed for taxes as necessary and avoid any potential issues with underpayments.
Capital gains taxes tend to be the most variable elements of our clients’ tax liabilities. Realized gains and losses fluctuate each year with cash needs, investment management priorities and the availability of capital losses. Typically, capital losses, which can be harvested for tax loss purposes, are more abundant during down markets. Please reach out or connect us with your accountants if we can help you better plan for your estimated taxes.