Banks in Recession: Strategies to Retain Customers and Compete with Lower Rates
How to save face with your depositors so you can survive to enjoy the next super cycle in the American economy in the years to come.
How Banks Compete During Recessions
Hello Sifters, it’s never been more relevant today, the word recession. Along with the highest interest rates in years. That leaves competing banks in a precarious position.
In today's discussion, we will delve into the topic of banks competing with each other and strategies to prevent your depositors from switching to a bank that offers lower loan rates, especially in times of economic recession and or high interest rates.
Kyle Dempsey & Miguel Faria E Castro form the Federal Reserves research department do a great job. I’ll do my best to make justice of their work and explain it simpler.
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Banking on Relationships: How Customer Capital Shapes Economic Recovery in Times of Crisis - Insights from Kyle Dempsey, Miguel Faria e Castro
A recent paper by Kyle Dempsey and Miguel Faria e Castro delves into the relationship between banks and lenders, arguing that long-lasting relationships between banks and their customers have significant implications for the speed of economic recovery following a financial crisis.
The paper suggests that customer capital interacts with capital constraints specific to the banking industry, which is critical to understanding dynamics around recent recessions. In simpler words when banks don't have enough money to lend out, it can affect the customers who want to borrow from them. This is called "customer capital," which means the money that customers want to borrow from the bank.
So, when there is a recession, banks might have less money to lend out, which can make it harder for customers to borrow money. This can make the recession worse because people might not be able to buy things they need or want, and that can hurt the economy even more.
It's important to understand how customer capital (the money that customers want to borrow from the bank) and capital constraints (when banks don't have enough money to lend out) work together, especially during a recession, so we can all recover.
You can read about how the US government is bracing for this in the article below.
The authors use a representative borrower model to demonstrate that loan demand at a given bank is decreasing in the loan rate spread over the benchmark, while increasing in the relative habit of existing lending relationships. In other words it’s like saying that if one bank offers a lower interest rate compared to another bank, more people might want to borrow from that bank because they don't have to pay back as much extra money. This is called the "loan rate spread over the benchmark."
But, the paper is also saying that if you already have a good relationship with a bank (which means you've borrowed from them before and paid back the money on time), you might still want to borrow from that same bank even if they offer a higher interest rate compared to another bank. This is called the "relative habit of existing lending relationships."
Understanding Banking Industry Equilibria: The Relationship Between Prices, Market Power, and Capital Buffers & How to Collude With Trying
Each bank is assumed to be monopolistically competitive, setting its loan price and taking the demand function of the borrower as given in the papers research.
The paper establishes two important results about banking industry equilibria. This paper is part of a broader empirical literature that studies the efficiency and stability consequences of banking market power. Simply put, banks can have a lot of power and control over how things work in the banking industry.
A steady state general equilibrium in the banking industry is a joint distribution of prices and customer capital. Meaning all the banks can agree on some prices for different things like loans and what they charge for them.
They also found out that there are certain things that affect how banks work and how much extra money they charge people who want to borrow money from them.
One important thing they found out is that there is a certain way that things work in the banking industry that stays the same over time.
When it is less costly for borrowers to adjust their portfolio of loans, banks have lower effective market power, resulting in lower profitability. As a result, banks increase their capital buffers, and aggregate net worth increases. The baseline model features a more sluggish recovery in net worth than the competitive model.
Remember, it's easy for people to borrow money from different banks and switch or swap between them, the banks can't charge too much money, which means they make less money. So, the banks have to be careful with their money and save more of it. This makes them richer over time, but it takes longer for them to become rich than if there were lots of banks competing with each other. This is a survival strategy and bring unintended collusion between what we’re competitive banks which can shock.
How to Reduce the Effects of Recessionary Effects on Your Bank & Come Out Strong During the Next Super Cycle After Shaking Off the Shocks
To reduce the effects of shocks, banks should expend customer capital. Two measures of customer capital are constructed - a measure of the fair value of a bank holding company's loan portfolio and the Lerner index.
The Lerner index has been widely used in banking as a measure of market power.
We first study how changes in a bank holding company's customer capital relate to subsequent growth in market value in a period of equal length after the crisis. Banks that expended the most customer capital tended to recapitalize faster and fare better in the post-crisis period, even when controlling for the size of the shock.
This is discussing how banks can minimize the damage caused by economic shocks by using customer capital, which refers to the value of a bank's relationship with its customers. Another reason the new swap lines for assets to meet deposits was smart.
Kyle Dempsey & Miguel Faria e Castro developed two ways to measure customer capital: one based on the fair value of a bank's loan portfolio and the other using the Lerner index, which is a measure of market power used in the banking industry.
They found that banks that used more of their customer capital were able to recover more quickly from a crisis and perform better afterward, even when the size of the crisis was taken into account. In other words, customer capital seems to be an important factor in a bank's ability to weather economic storms. Again, why the swift depositor funding program was vital, we need to give credit where it is due. Scroll up to read the article on the bank funding programing terms, it’ll make a lot more sense.
To measure interest rates, Kyle Dempsey & Miguel Faria e Castro use Ratewatch, which collects weekly data on interest rates offered by bank branches on different products. They used the resulting estimates to compute a measure of bank holding company customer capital in a given MSA year.
In conclusion, this dynamic general equilibrium theory highlights the crucial role of customer capital in the banking industry.
Banks with high customer capital are those for whom lenders have a strong endogenously built relationship, resulting in better resilience and faster recovery from shocks.
Some banks are called "important" and others are called "not so important." I know we all have heard these terms recently and wether we like it or not.
During the recent times, many people have moved their money from the "not so important" banks to the "important" ones. Next’ we’ll talk about retaining them.
Keep Your Customers Happy During Bad Times, Take Less Profits & Use the New Federal Reserve Swap Program for You to Meet Your Depositors
Banks that have established lending relationships with their customers are able to charge higher interest rates with a smaller cost to total loan demand compared to other banks, according to a recent study.
The authors of the study argue that market valuations are not accurate measures of the economic value of banking operations due to the implicit value of government guarantees.
To compute the fair value of equity, the authors use a simple valuation model based on the average maturity of bank loans and average charge off rates of repayment and default.
The study also provides proof of Proposition 3 of the theory of bank finance and lending, which is based on the spread elasticity of bank-specific demand and customer capital elasticities.
The optimal pricing policy for banks is to set q=1/Ralways, according to the study.
Also there has been provided a proof of Proposition 4 Stationarity Proof and suggest the use of nested golden section with a choice as the outer loop to compute the value associated with the current τ a. The study highlights the importance of lending relationships for banks and the need for accurate measures of economic value in the banking industry.
Wrapping Up What We’ve Learned About Saving Face as a Bank and Retaining Your Customers During Recessions So You Can Survive
All this jargon means one thing for you as a banker, M&A advisors, wealth manager or any of the other consultants who read The Tweetsift Report. Remember these two things and you may save your bank or one of your clients.
Banks can make the most money by setting loan prices in a certain way, and they recommend a specific pricing policy to achieve this. So keep the rates low even if your spread is thin and you aren’t making much profit. You want to make it for the long run, don’t die out before the next super cycle, see more on the Benner Cycle:
Additionally, and the most important thing, the study emphasizes the importance of maintaining good relationships with customers and using accurate measures to evaluate the bank's value. They won’t leave you for another bank for less of a rate. But they may take their money out and move it to a Important Bank, it is bank run season.
I hope this paper is not only informative but helps you take actionable steps towards guarding your depositor bases, keeping them happy during bad times and staying alive until the next super cycle comes.
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