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By Armel Romeo Kouassi, Head of Balance Sheet Modeling with Senior Vice President, Northern Trust
Can you provide an overview of the challenges you see with the increase in liquidity on balance sheets?
We lived through a time that will be remembered in future history books. 2020 has presented the Banking sector with one of the most complicated economic circumstances the industry has ever experienced. It was the perfect storm: synchronized market volatility, economic standstill, interest rate collapse, massive government intervention to provide immediate financial assistance and reallocate industrial capacity to meet urgent medical needs, collapse in energy prices, and so on, have defined this economic downturn. To add fuel to the fire, the oil market battle between Russia and Saudi Arabia has caused further shock on the supply side of oil.
Unlike most financial crises, this was not a banking crisis but of course it can spillover into banking crisis. Majority of banks were agile navigating this crisis, addressing immediate challenges by protecting staff, moving to remote working, and using their balance sheet to supports their clients. Even though Banks have been able to ride out the storm the increased liquidity and prolong low rates have paused some challenges. Some of the challenges are listed below:
Deposit’s growth and pressure on capital management: Deposit growth has been aided by the federal reserve injection of liquidity and the government stimulus. Overnight banks have seen their deposits growing by double digits putting pressure on Tier 1 Leverage ratio. During the height of pandemic, the Federal reserve provides capital relief by suspending the supplementary leverage capital ratio. The Fed introduced the SLR relief for banks last year as it sought to support the economy amid the coronavirus pandemic. Under the exemption, it allowed banks to hold extra Treasuries and deposits without setting aside capital for potential losses. The direct implication of letting the relief expire is tighter bank-level controls over leverage capital. As of March 31st, the relief expired. In general, some Banks are under pressure to either raise expensive additional capital or chase deposits away from the balance sheet.
Margin compression: Bank balance sheets remained challenged with excess liquidity. Deposit growth exploded post COVID-19. Meanwhile, loan growth remained hard to come by as banks tightened underwriting standards in many asset classes, while borrower demand remained weak. Banks do not appear to have deployed much of the excess liquidity since the end of the third quarter either, reporting that demand for commercial and industrial credits and commercial real estate loans remained weak.