What Is the Primary Role for Health System Financial Reserves?

Current Funding Environment

The beat rolls on: benchmark rates remain below long-term averages; credit spreads remain higher versus 2021 but have been stable over the past several months; funds flows turned slightly positive after several weeks of modest outflows. Overall, market indicators remain generally favorable, but continued low issuance means there is little guidance on how resilient current pricing levels might be.

SIFMA reset this week at 3.86%, which is approximately 76% of 1-Month LIBOR and represents a +169 basis point adjustment versus the April 12, 2023, reset.

An Anchor or an Engine?

OK, so maybe the 2023 bank crisis is only mostly dead. Last Friday, Moody’s downgraded 11 regional banks based largely on the credit implications of ongoing deterioration in uninsured deposits. The quote of the week is Moody’s observation that recent developments have “called into question whether some banks’ assumed high stability of deposits, and their operational nature, should be reevaluated.” It turns out that uninsured commercial bank deposits are just a form of low cost but highly contingent financing, which in the wrong resource positioning construct turns them into a risk engine. Who knew?

Unfortunately, this thing we might label “excess uninsured deposit liquidity” has been a driver of bank balance sheet growth, so any sustained rebalancing from here is just one more manifestation of the great liquidity unwind that we expect will have a long tail and lots of unintended consequences. Almost a month ago there was a JP Morgan analysis suggesting that roughly one-half of the $1 trillion that had moved out of “vulnerable” regional banks had gone into larger money-center banks, with the other half going into financial securities. One of many unknowns is what impact this deflation of regional bank resources (deposit outflows plus declining stock values) might have on healthcare credit and capital access; this question gets a lot bigger when you factor in the whole bank universe as well as the “shadow banks” that became part of the grease that allowed credit and capital to flow so freely over the past several years. The massive liquidity inflows that were favorably distortive going in (all sorts of funding channels opening and generating terrific pricing and terms) are likely to be negatively distortive going out (funding channels drying up quickly and various dependencies—some quite opaque—rapidly becoming problematic).

At the request of the American Hospital Association, Kaufman Hall recently published a new report on “The Essential Role of Financial Reserves in Not-for-Profit Healthcare.” It is a terrific piece that covers a lot of important ground. One thing it makes clear is that financial reserves play a diverse set of roles in the typical healthcare organization; and these roles shift in priority as organizations move through different internal and external business, credit, and capital cycles. This principal is true for every balance-sheet-reliant organization—commercial bank or not-for-profit healthcare—and the important question in each cycle is whether the primary role of financial reserves is to be an anchor or an engine?

But before getting into roles, the foundational question must be reliability—are these resources something you can build on or not? The 2023 bank crisis is rooted in layering long-term risk positions on top of unreliable collateral, which is a variation on the same problem we saw in 2008 (mismatch in risk versus collateral across financing company balance sheets). The financial resources at most healthcare organizations are long-term reserves that are fully controlled and appear to be reliable. But reliability gets eroded by things like sustained investment or operating losses (realized risk), high capital funding, or diversion into a restricted or quasi-restricted role (typically to secure a financial commitment). The important distinction is always between technically unrestricted reserves versus what might be called “target reserves,” which are not only unrestricted but also formally and informally unencumbered.

Every balance sheet resource is part of some role defining collateral versus risk equation. Anchor reserves support some resiliency purpose, like buffering operating volatility, maintaining a rating position, or creating external debt capacity. Engine reserves live within the world of return and are positioned with the primary goal of driving specialized financial returns. Understanding what your resources are, the role your decisions place them in, and then positioning them in a role-responsive way is the most important management initiative for every balance-sheet-centric organization.

Today’s troubled banks made two errors: they assumed unreliable resources (uninsured deposits) were anchors but then they went further and positioned those unreliable resources as engines. As deposit growth outpaced lending capacity, these banks turned to risk strategies to generate returns to try to avoid earnings drag from what would otherwise have been underperforming assets. Not every regional or smaller bank followed this playbook, but the troubled ones did. As core operations struggle, should not-for-profit healthcare organizations transition financial reserves into risk positions in pursuit of an engine to offset core cash-flow drag? This is a critical management and governance decision; and getting to a right and sustainable strategy requires both an excellent decision-support framework followed by back-end clarity that what has been designated as an engine is no longer an anchor and vice versa.