Banking once was personal. I remember being introduced to the local bank president when I opened my first passbook savings account, decades ago.

In those times, our family was loyal to the community bank which held our mortgage, savings, checking accounts and safety deposit box.

Like the family doctor, it made good sense to do business with someone we knew, and someone who knew something about us.

Things changed over the years as banks were deregulated and became larger with a slew of mergers which increased their size. Today, just a handful of large banks dominate the financial services industry. In fact, the top four: J.P. Morgan, Bank of America, Wells Fargo and Citibank hold almost half of all American bank deposits. So-called super-regional financial institutions often serve as the primary bank in a community and the local manager is constrained by cookie cutter policies and procedures. On the other hand, customers may now have access to services which otherwise might not be available.

For a long time, banking was rather boring. The industry attracted professionals desiring a stable environment, perhaps foregoing opportunity in exchange for stability and less stress. The 3-6-3 rule was the norm from the 1950s through the 1970s. In 3-6-3, bankers paid 3 per cent on deposits, lent the money out at 6 per cent and were on the golf course by 3pm!

During the 1980s banking experienced a wave of deregulation beginning with the Depository Institutions Deregulation and Monetary Control Act. This act deregulated depository financial institutions and was intended to strengthen the Fed's control over monetary policy.

Significantly, the act removed restrictions on opening bank branches in different states. Then, in 1999 the Gramm-Leach-Bliley Act repealed many aspects of the landmark Glass-Steagall Act of 1933 which had separated investment banking and insurance services from commercial banking.

From 1999 onward, banks were allowed to provide commercial banking, securities, and insurance services under one roof. Thus began the era of mega banking.

From the turn of the last millennium, bank mergers reached a frantic pace. From 1990 to 2022 the number of US bank charters has shrunk from 12,225 to 4,135. However, even though two thirds of the banks were merged out, 4,000 is still a comparatively big number. For example, Canada has just 34 banks and the UK has 347.

Despite government oversight, bank failures periodically happen and their results are not always predictable. Last month, Silicon Valley Bank and Signature Bank in New York were abruptly placed into receivership, representing the second and third largest bank failures in American history.

Meanwhile in Europe, banking stalwart Credit Suisse was forced into a shotgun merger with competitor UBS as the 166-year-old bank teetered on the edge of insolvency.

The source of the recent bank failures was two-fold. First, the Fed Reserve’s extreme tightening of monetary conditions which included parabolic interest rate increases over a short period of time, sent bank investment portfolios plunging.

Banks are mandated to hold large amounts of investment grade bonds but when interest rates rise, bond values decline. SVB has what is considered a long duration portfolio, making their fixed income investments extremely vulnerable to rising rates.

Secondly, deposits are no longer sticky. In this age of mobile banking, customers can easily move funds from one institution to another. In the case of Silicon Valley Bank, when word got out that SVB faced insolvency, SVB customers yanked deposits in record time.

SVB lost over half their deposits in just two days! Technology gave the term “run on the bank” a new meaning. SVP was forced to liquidate its portfolio at bargain basement prices, leading to its failure.

After two major bank failures, investors are pausing to consider the longer-term viability of commercial banking and what it means for the economy overall. After outperforming the market last year, bank stocks have dramatically underperformed so far in 2023.

Today’s financial sector is moving at the speed of technology. Bank depositors are now demanding a return on their savings accounts which is a least equal to the yield on risk-free short term US Treasury notes which are paying around 4.5 per cent. Furthermore, no one wants to leave more than $250,000 – the Federal Deposit Insurance Company limit – in any one financial institution.

This has translated into massive deposit flight from all banks with the smallest institutions being impacted the most. Between March 10 and April 7, approximately $280 billion flooded into institutional money market funds from banks. As banks are only allowed to lend out a certain percentage of their deposits, lending has recently fallen off a cliff and this is causing further pressure on an already decelerating global economy.

Going forward, banking may be less profitable and riskier for smaller institutions. A major source of profitability is a financial institution’s net interest margin.

Most banks were spoilt by over a decade of paying zero to one per cent on deposits while being able to lend at much higher rates. That game is over for good, and this will lead to less profits as deposit holders must be competitive with alternatives.

In terms of bank credit risks, most economists are calling for a mild to severe recession before year-end. In a contracting economy, we can expect to see some cracks in the credit market.

Commercial Real Estate loans, especially those backed by office buildings are particularly vulnerable. CRE loans, unlike mortgages, typically balloon and need to be refinanced after five years. Thus, many loans sitting on bank balance sheets will need to be repriced from low rates to much higher interest rates putting pressure on borrowers. Office property loans have the additional issue of more people working from home.

In this environment, we like the largest and most diversified financial institutions. Companies such as Morgan Stanley have a large and growing presence in wealth management which is less cyclical than conventional lending.

And finally, corporate bonds and preferred stock of larger banks are worth considering at these depressed levels. Many issues are trading with yields of 6 to 8 per cent, and offering returns historically wide to US Treasury bonds of similar duration.

Bryan Dooley, CFA, is the Chief Investment Officer at LOM Asset Management Ltd in Bermuda. Please contact LOM at +1 441 292 5200 or visit www.lom.com for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.