Time to Batten Down the Hatches

As I write this in mid-April, the S&P 500 Index is down 15% from its all-time peak in February, and fears of inflation, recession or both are daily topics. Tariff wrangling is center stage. There is uncertainty around what actions the Federal Reserve might take, and bank credit concerns are becoming more pronounced. Tomorrow, a social media post could swing expectations in a completely different direction. In short, we are in a season of high volatility. When we don’t know where we’re headed, let alone how tumultuous the journey might be, how do we prepare our banks?

Recently, a bank director asked me, “Is it time to batten down the hatches?” That expression is interesting and appropriate, stemming from old nautical terminology for preparing ships for bad weather. Sailors would use wooden strips, called “battens”, to secure their hatch covers against water getting in and damaging cargo. So, the word batten is a noun, referring to the protective item, and a verb — “to batten” or to take the defending steps.

What Battens Do Bankers Have?
While different institutions may have a variety of precautionary resources they can deploy against volatility, there are two common battens of primary importance to all: capital and liquidity.

Capital serves as the first and strongest protection against trouble — rate pressures, credit erosion, economic slowdown and more. Having enough capital for these situations when they arise is necessary but having too much capital, through ineffective management or under-allocation, can diminish earnings and threaten ongoing economic viability.

At year-end 2024, over 500 banks had capital levels that would be considered structurally impaired based on data from our proprietary risk management analysis, PT Score. At the same time, most companies had capital levels that greatly exceeded what’s needed for normal expectations. Both conditions carry risk.

Liquidity is nearly as important when facing problematic events or trends. In 2023, we experienced the rare but dynamic impact of a systemic liquidity event when a potential industry meltdown was staved off, but the danger of a liquidity crisis was felt by all.

We experienced unprecedented inflows of demand deposits during the pandemic, which have since run off, but even today, demand deposits are 15% higher as a proportion of total deposits than historical norms, according to an analysis of data from Federal Financial Institutions Examination Council call reports.

Observed statistically, liquidity appears sound. But here too, we must consider potentially significant volatility. Many depositors are accepting very low yields to preserve their liquidity to meet the needs they might face in the same unpredictable conditions we fear. In the event of a downturn, depositors might quickly draw on these reserves; under renewed inflation, they could seek higher yields. Liquidity is defensive, but will it be there when it’s needed?

Battening Down
Capital and liquidity are protective but can also face risks under volatility, so how do bankers batten down, and what steps should we take to prepare?

When it comes to capital, the guidance put forth in the Office of the Comptroller of the Currency Bulletin 2012-33, Community Bank Stress Testing, is a great place to start. Using multiple stress scenarios to quantify potential exposures, banks can reassure themselves that their capital is sufficient to provide security or begin taking remedial actions. Further, while the focus in 2012 was primarily on undercapitalization, the results of this testing would reveal for many companies that even given those stress cases, they are carrying too much capital and should deploy it more efficiently to help protect against the alternate risk of under-earning and losing their independence long term.

Similarly, when it comes to liquidity, banks should run funding stress scenarios to test how their liquidity would hold up under both acute events and longer periods of deposit erosion and funding recomposition. Some may find they have more than enough liquidity even in stress cases and should consider ways to potentially earn more with it. Others may discover that their liquidity is threatened under stress and should take actions that, while reducing near-term earnings, secure against those dangers.

Now More Than Ever
Banks should practice ongoing stress testing, especially in terms of capital and liquidity, even more so in volatile times. As a former regulator, I am concerned about those banks deficient in one or both categories. But I am also concerned about banks carrying too much of one or both. Institutions doing this might face long-term earnings risks to their viability.

Performance Trust has been advising community banks for 30 years and is a registered broker/dealer, member of FINRA/SIPC. This is intended for educational and informational purposes only and is not intended to be legal, tax, financial, or accounting advice or a recommended course of action in any given situation. This is not an offer or solicitation to purchase or sell securities. The Information is subject to change without notice.