The Bank of England today released the October 28 Financial Stability Report which paints a grim picture of the UK and global financial system. While the report focuses on the UK, its analysis and insights are valauble for the US as well.

While the reports says that the banking system has somewhat stabilized, significant risks remain. These include:

Hedge Funds

The report says:

"Recently, hedge funds have also experienced additional funding pressures due to redemption requests and a risk is that these could increase. Redemptions tend to increase following a period of weak returns. In 2008 Q3, hedge funds had one of their worst quarters on record, losing a little over 10% on average (Chart 5.6). Bank contacts report that redemption requests have been high in particular from funds of hedge funds (FoHFs) in the light of their own redemption requests. Hedge funds generally operate ‘gates’ that place an upper limit on aggregate redemptions in any given quarter. A risk for FoHFs is that hedge fund gates prevent them securing the liquidity that they need to meet redemption requests. FoHFs often have liquidity lines with banks on which they could draw in such circumstances. This would transfer the need for liquidity from FoHFs to banks. Hedge fund liquidity needs may help to explain sales of relatively liquid securities such as developed-country and emerging market equities, the prices of which have fallen sharply in September and October."

In plain English, investors are pulling their money out of hedge funds. Many hedge funds are not liquid but have bank lines which they can use to meet investor requests to be cashed out. This puts more of a strain on banks because they must pay out the funds. In addition, the selling we've seen in emerging markets may be hedge funds selling stock to meet redemptions.

No one seems to think we're at the end of hedge fund pressure.

Insurance Companies

Significant risks also remain with insurance companies:

"As long-term investors, insurance companies tend to hold a significant proportion of their assets in equities and corporate bonds. The marked decline in the value of these securities in 2008 has generated capital losses for some UK insurance companies, which is reflected in rising CDS spreads and falling equity prices for the sector (Chart 5.7). Unlike banks and hedge funds, however, insurance companies generally do not employ much leverage and have long-term liabilities. So insurance companies seem relatively well placed to avoid liquidity difficulties. Risks could arise, however, if the value of insurance companies’ investments were to fall below regulatory capital requirements. This was an issue in the bear market of 2003, but regulatory reforms introduced in 2004 have reduced the likelihood of this risk by using a more risk-based capital requirement with countercyclical resilience testing. A second risk is that credit ratings of insurance companies could be downgraded. Counterparts to any derivatives trades would then increase margin requirements, increasing the liquidity needs of the insurance sector."

The BofE seems less concerned about insurance companies.

Solution

Banks are increasingly relying on short term funding to meet their liquidity needs. This creates risk because if the funding dries up, they will not be able to roll their debt over, resulting in default. One of the main solutions the BofE sees to this problem is a return to customer deposits. The Bank writes:

"Over the medium term, banks can reduce vulnerability to rollover risk by financing a greater proportion of customer lending through customer deposits. Such adjustment would result in a narrowing of the customer funding gap. But banks’ willingness to raise customer deposits will be constrained by cost. In the United Kingdom, increased competition for customer deposits has pushed up the cost of such funding."

And there you have it. The explanation for why deposit rates in the United States have not fallen as far or as fast as the drop in Treasuries and the Fed Funds rate. Your cash is a valuable, steady source of funding for banks.

And it will only become more valuable over time. Don't part with it easy and make sure you are getting the best rate on your savings or money market accounts, or CDs.

Alpha Bank and Trust, Alpharetta, Georgia, was closed today by the Georgia Department of Banking and Finance, and the Federal Deposit Insurance Corporation (FDIC) was named receiver. To protect the depositors, the FDIC entered into a purchase and assumption agreement with Stearns Bank, National Association, St. Cloud, Minnesota, to assume the insured deposits of Alpha Bank & Trust.

The two branches of Alpha Bank & Trust will open on Monday, October 27, 2008 as Stearns Bank, N.A. Depositors of the failed bank will automatically become depositors of Stearns Bank, N.A. Deposits will continue to be insured by the FDIC, so there is no need for customers to change their banking relationship to retain their deposit insurance coverage.

Over the weekend, customers of Alpha Bank & Trust can access their insured deposits by writing checks or using ATM or debit cards. Checks drawn on the bank will continue to be processed. Loan customers should continue to make their payments as usual.

As of September 30, 2008, Alpha Bank & Trust had total assets of $354.1 million and total deposits of $346.2 million. Stearns Bank did not pay the FDIC a premium for the right to assume the failed bank's insured deposits.

At the time of closing, there were approximately $3.1 million in uninsured deposits held in approximately 59 accounts that potentially exceeded the insurance limits. This amount is an estimate that is likely to change once the FDIC obtains additional information from these customers.

Alpha Bank & Trust also had approximately $16.8million in brokered deposits that are not part of today's transaction. The FDIC will pay the brokers directly for the amount of their insured funds.

This is the sixteenth bank failure of 2008. By comparison, at the height of the Savings and Loan Crisis in the early 1990s, over 500 banks failed per year. At both a number and asset level, the bank failures we've seen in 2008 are mild in comparison. 2009 may be a much tougher year.

Bank acquisitions, which slowed a bit after the Wells, Wachovia, and Citi dance are now back in force. PNC Corp. announced today that it was buying National City for approximately $5.2 billion. In 2007, National City had $150 billion dollars in assets and was one of largest financial companies in the United States. In the past year, National City's stock has taken a tremendous beating falling from a 52 week high of $24 to $2. It displayed many of the sympoms we've seen of many distressed bank - dividend cuts, capital raises, cratering stock price, and suddenly high interest rates on cds and savings accounts. National City suffered from a bad loan portfolio in Ohio, a state that has been hard hit by foreclosures. To make matters worse, National City recently spent $2.1 billion buying up banks in Florida, one of the hearts of the housing meltdown.

PNC is significantly healthier. While its stock price has fallen from a 52 week high of 89, it is now trading at 59. That's hardly the collapse we've seen with distressed banks. PNC is also tapping the TARP Capital Purchase Program and plans to sell $7.7 billion of preferred stock to the U.S. Treasury to help with the deal.

The FDIC must be breathing a bit easier since that removes National City from its radar of potential failed banks.