Deposits—The Lifeblood of Banks
Over the past three months regional bank deposits have dried up, much like the Colorado River behind the Hoover Dam. Without new deposits, these banks face an existential crisis—as demonstrated by the collapse of Signature Bank, and Silicon Valley Bank earlier this year. With First Republic Bank’s announcement of over $100B in deposit outflows throughout 1Q ‘23, the drought appears to be spreading. But why do deposits matter so much to banks, what happens to a bank’s operations when deposits dry up and where are the deposits going? We tackle this and more in the post below—let’s dive in!
An overview of how banks work
When startups deposit their capital into a bank, the bank records the transaction onto its books and the account in the startup’s name. Then the bank pools the funds with the other deposits it collected over the period (usually a single day) and begins to allocate the capital. This allocation takes place across multiple asset classes and types. Some of the funds go into an account to be used for lending, some of the funds go into an account to be used for investing, and some of the funds are placed in an account that is kept liquid at all times. When startups initiate a withdrawal, either through ACH or Wire transfer, the bank pulls from its liquid account, and if not enough, is forced to either borrow funds overnight from another bank (EFFR, OBFR, SOFR…etc.) or liquidate one of its investments (usually government securities). Normally this process is fairly smooth, however, when lots of startups or individuals pull funds from their accounts, the bank experiences a cash crunch.
An overview of “bank runs”
As mentioned above, banks are relatively stable, it's only when a large number of customers withdraw their deposits at the same time, that they experience issues—this is known as a “bank run”. Bank runs typically happen when there is a loss of confidence in a bank's ability to meet its obligations, such as paying out customer deposits or fulfilling its loan commitments. They can also occur when banks announce major losses resulting from a particular investment, even if the loss is not realized, news of a major economic event, or a sudden loss of confidence in the banking system as a whole.
Bank runs are problematic, because they undermine the stability of the entire banking system, cause significant economic disruption, and harm the livelihoods of individuals and businesses who rely on banks for their financial needs. In extreme cases, bank runs can result in a bank being forced to close its doors—such was the case for Signature Bank and Silicon Valley Bank—and depositors losing their balance over the FDIC Insurance limit of $250,000.
Why deposits are so important to banks
Banks need deposits for several reasons, primarily because their operations would grind to a halt without them. Banks leverage deposits to lend out to other startups and small businesses, to invest in various financial products, such as stocks, bonds, and other securities, to meet regulatory requirements, and to absorb potential losses from defaults on loans or other investments. A bank without deposits is like a car without gas, it simply wouldn’t run.
What happens to a bank’s operations when deposits dry up
As mentioned above, deposits are the lifeblood of banks, without them, banks cease to operate. But what happens when deposits just start to dry up? Well, that’s a quite different story.
Most banks maintain a minimum reserve ratio of 10%. That means for every dollar of deposits stored with them, they set aside ten cents to be kept liquid at all times. Most times the cash they have on hand and these reserves are enough to satisfy their withdrawal requests, though sometimes it's not enough.
At the beginning of a run, banks tap the deposits they received that day and potentially the cash they have on hand. As the run picks up steam, the cash on hand/reserves start to become depleted and they start selling off assets. As the run further intensifies, they sell more assets and begin borrowing from other financial institutions or the Federal Reserve. At the height of a run, the withdrawal requests overwhelm the bank, which can’t unwind or deleverage its positions fast enough and the bank goes under.
Even when banks survive a ‘run’, the deposit outflows leave them in a disastrous financial position. The banks are typically forced to recognize massive losses due to the sale of assets, their ability to make loans and generate revenue is diminished, and their reputation in the minds of consumers and businesses is tarnished. In those cases, even though they survived they may collapse anyways—as is the case for First Republic Bank, which is currently on “life support”.
Where deposits go during and following a bank run
During bank runs, deposits flee to safety. This safety manifests itself in one of two ways, either legacy brands who have dominated the industry for decades or new up-and-comers who offer safety through technology. In the run earlier this year, the majority of deposits (50%+) fled to JP Morgan Chase, Wells Fargo, and Bank of America, which are legacy banks. Another significant percentage (~30%) went to the regional banks First Republic, Bank of the West, BMO Harris. The remaining 20% went to the so-called “BAM Fintechs”: Brex, Arc, and Mercury.
The “BAM Fintechs” are not banks, but partner with them and offer safety through technology. They leverage cash sweeps to diversify startups’ cash across multiple banks increasing the FDIC Coverage a single startup receives. Arc, for example, provides up to $5.25M of FDIC Coverage through Evolve Bank and BNY Mellon’s system of partner banks.
After the initial flight to safety, depositors re-evaluate their cash management practices and often stumble across treasury management. Through treasury management platforms, startups can allocate their capital across a variety of different accounts to protect 100% of their deposits. This is accomplished through a series of operating accounts that offer $250k in FDIC Coverage, money market funds that offer $500k in SIPC Coverage, cash sweeps that offer several million dollars in FDIC coverage, and US Treasury bills that protect their remaining cash balance.
The FDIC’s Involvement (or lack of) in a Bank Run
The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the United States government that provides coverage for deposits at banks and savings associations. The FDIC works to prevent bank runs by monitoring banks' financial health and by taking steps to prevent banks from becoming insolvent. During bank runs, the FDIC may step in to provide guidance on how best to handle the volume of requests. They may also help line up capital injections from other financial institutions and even the Federal Government.
In the event of a bank failure, the FDIC has the authority to take it over and manage the organization to ensure that depositors are protected. Following a bank failure, the FDIC sells off the assets of the failed institution and distributes the proceeds to depositors whose balance exceeded the $250k limit.
Closing thoughts on bank deposits as the lifeblood of banks
Banks rely on deposits for every aspect of their operations. Without deposits banks fail. Without new deposits, banks also fail, and it's a much slower and more painful process. Earlier this year we experienced a black swan event, the failure of two major banks: Signature Bank and Silicon Valley Bank. We’re currently experiencing the failure of yet another due to major deposit outflows and concern over the bank’s ability to meet its obligations.
If you’re concerned about that bank and are interested in diversifying your cash through money market accounts, money market funds, and US Treasuries, check out Gold. It provides up to $5.25M of FDIC Coverage, $500k in SIPC Coverage, and access to US Treasuries to safeguard the rest of your cash.