Don’t Bank On It: A Nationwide Digital Bank

Don’t Bank On It: A Nationwide Digital Bank

With this article, we continue our new series, “Don’t Bank On It,” which we intend to write for the foreseeable future. Those of you who have been following our public banking articles know that we have been highlighting the major existential issues currently sitting on many bank balance sheets.

In this series, we focus on the existential issues found on one specific bank’s balance sheet. We also challenge readers to figure out which bank we are covering in each article.

Our third highlighted bank is a publicly listed U.S. bank with roughly $30B in assets. It is a nationwide digital bank, so it is not confined to a traditional branch footprint. It offers deposits and loans across the country through online and mobile channels, as well as affinity partners.

Extremely high exposure to shadow banks

This bank has one of the highest exposures to shadow banks among U.S. banks with more than $10B in assets. Outstanding loans and unused lending commitments to shadow banks amount to more than 500% of the bank’s total equity, which is extremely high. The bank is actively lending to private-credit funds, real-estate sponsors, asset-backed finance companies and other types of shadow banks.

Those who follow our banking research already know the major risks lurking in the shadow-banking industry, which many global regulators now identify as a key threat to global financial stability.

The problem is not only the size of this exposure. It is also the opacity of the underlying risk. Loans to private-credit funds, real-estate sponsors and asset-backed lenders may ultimately depend on the same collateral, the same borrowers and the same refinancing conditions.

High exposure to CRE

In addition to its extreme exposure to shadow banking, this bank also has very high exposure to commercial real estate. CRE loans amount to more than 300% of its equity.

Another major concern is the overlap between the bank’s shadow-bank loan portfolio and its CRE book. Some loans classified as lending to non-bank financial institutions may ultimately be backed by commercial properties, bridge loans, construction projects or real-estate borrowers.

This creates a complicated and potentially dangerous situation. The bank may appear diversified across several lending categories while remaining exposed to the same underlying risk.

If commercial-property values fall, refinancing becomes harder and private-credit borrowers come under pressure, several parts of the bank’s loan book could deteriorate at the same time.

Asset quality is already deteriorating

The current economic environment remains relatively benign, and the credit cycle has not fully turned yet. Despite this, the bank reported a sharp increase in loan-loss provisions in the first quarter, while its cost of risk almost tripled.

This is important because the bank’s loan portfolio is concentrated in areas where losses may remain hidden until borrowers lose access to refinancing or collateral values begin to fall.

Current non-performing-loan ratios may therefore offer false comfort. In private credit, structured finance and commercial real estate, credit quality often appears strong until it suddenly does not.

Loan-loss reserves also look low relative to the size, complexity and concentration of the bank’s risk exposure. They may be sufficient against currently reported problem loans, but they could prove inadequate if losses emerge simultaneously across CRE, shadow banking and specialty finance.

Reliance on wholesale liquidity

As noted above, this is a digital bank and, like many digital banks, it offers relatively high deposit rates.

For now, the bank can afford to do this because it lends in risky markets where competitors charge wider spreads, allowing it to earn a high yield on its assets. But this model depends on the bank continuing to generate unusually high returns from borrowers that traditional banks may be unwilling to finance.

Even a mild recession could put pressure on both sides of the balance sheet. Credit losses could rise just as depositors demand higher rates or move their money elsewhere.

Importantly, over the past year, the bank attracted almost $2B of expensive Federal Home Loan Bank funding. This suggests that deposit growth alone was not sufficient to finance its aggressive balance-sheet expansion.

Wholesale funding can support rapid growth in good times, but it also makes the bank more vulnerable to higher funding costs and tighter liquidity conditions.

Capital is too low for this model

The bank’s CET1 ratio is below 11%. That may be legally adequate, but in our view it is far too low for a bank with such an aggressive lending model and extreme exposure to both shadow banks and commercial real estate.

The bank does not need a catastrophic level of defaults to face serious pressure. Its exposures are so large relative to equity that even modest losses across several correlated portfolios could consume a meaningful share of its capital.

Conclusion

This is not a conventional bank but a highly leveraged institution exposed to shadow banking, CRE and continued access to cheap liquidity. Even a mild recession could expose correlated losses large enough to seriously erode its thin capital base.

Can you recognize this bank? If not, come to StockWaves at ElliottWaveTrader.net to identify it and view not only the fundamentals report but the Elliott Wave analysis to assist in making investing decisions.