While rising interest rates are normally a boon for banks, the current banking crisis shows that faster rate hikes from ZIRP (the Fed's zero interest rate policy) have their negative impacts on the nation's hundreds of smaller banks.

And recently -- even before the current banking collapse ignited by the Silicon Valley Bank debacle -- KeyCorp (KEY Quick QuoteKEY - Free Report) , revised its 2023 outlook for NIM (net interest margin) lower amid rising funding costs and "deposit betas."

I'll explain this NIM funding-deposit dilemma coming up. First let's check in with KEY after the SVB banking implosion...

KeyCorp CEO Chris Gorman was on CNBC's Squawk on the Street this week to discuss what his company is doing in light of the collapse of Silicon Valley Bank. He said that over the weekend, the bank actually had its biggest deposit growth year to date as cash deposits flowed to his $11 billion bank -- even after KEY shares lost over 30% in the past week -- as investors sought safer havens for their capital.

I don't want to pick on KEY just because it's currently a Zacks #5 Rank due to downward EPS revisions from Wall Street analysts. What I want to do is highlight the factors that are driving this systemic meltdown in a key infrastructure component of American business -- the Regional Bank.

Regional Bank Stress Puts Spotlight on Cash Management

Here was a note from PIMCO strategists this week...

Since the GFC (great financial crisis), the global financial system has undoubtedly become more resilient, thanks to new central banking facilities and regulations such as mandatory capital requirements. Thus under normal conditions, a bank can run a mismatched asset/liability maturity plan and lend its deposits out profitably.

It’s when depositors demand their funds back en masse that problems arise. Such is the inherent risk of our “fractional reserve” banking system, where banks need keep only a fraction of their deposits on hand to create loans in excess of the size of those deposits.

(end of PIMCO notes)

Mis-Match: Therein Lies the Rub

The arcane problem that most investors aren't familiar with is how Fed policies that artificially suppressed interest rates for far too long -- combined with the pandemic shutdown stimulus cash flood to businesses and individuals -- forced banks flush with new deposits to invest in the highest yielding assets they could find at the time, since they couldn't lend it any faster.

It wasn't just a Silicon Valley Bank problem. It was happening for lots of smaller banks that catered to wealthy investors and venture capital (VC) investors, such as First Republic Bank .

Those assets they "had to choose" from were Treasury and Agency MBS yielding sub-2%. And so when the Fed began hiking rates rapidly in 2022, all of sudden these bank balance sheets were left with a new problem...

"How do we keep and attract depositors who can go elsewhere for 3-4% yields while we are invested in instruments that yield less than 2%?"

That's a major funding problem for banks trapped in long-term gov/agency securities.

I was on the BlackRock institutional morning call on Wednesday and all their strategists sounded somber, sober, and sublime about the situation. Too bad I didn't get to ask them any tough questions.

I like the direct honesty of the PIMCO team much better.

Remember, in the "fractional reserve" banking system... banks "borrow short and lend long." This means they often borrow by taking checking and savings deposits -- which must be paid back immediately whenever depositors ask for them.

On the other hand, most of the money they lend out is tied up in long-term loans, such as mortgages.

With the sudden and dramatic rise off of ZIRP, instead of Net Interest Margin (NIM), most regional banks were staring into the abyss of Negative Interest Margin just to keep and attract deposit capital.

And there is a whole other realm of bank accounting rules where they can "silo" those gov assets as Hold-to-Maturity (HTM) and not have to acknowledge the unrealized losses on their balance sheet (remember as bond yields go up, their prices fall). But any of those securities they keep fresh for liquidation are called Available-for-Sale (AFS) and those do get "marked-to-market."

It's a complicated web of derivatives and leverage right now and that's why all regional and smaller banks are in the spotlight and the cross-hairs. As we've witnessed several bank implosions in the past week, the Wall Street sharks (short-sellers and their algo friends) will keep gunning for new blood.

I hope that doesn't happen for KeyCorp with its significance in small and medium-sized business lending.