How Deep Is the Rot in America’s Banking Industry?

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Banking is a trust trick. Financial history is littered with runs for the simple reason that no bank can survive if enough depositors want to repay at the same time. The trick, therefore, is to ensure that customers never have a reason to walk away with their cash. This is what the boss of Silicon Valley Bank (SVB), formerly America’s 16th largest lender, failed to demonstrate at a crucial moment.

The collapse of SVB, a 40-year-old bank established to cater to the Bay Area tech scene, took less than 40 hours. On 8 March the lender said it would issue more than $2 billion of equity capital to cover bond losses. This prompted an investigation of its balance-sheet, which revealed that half of its assets were long-term bonds, and many were underwater. In response, $42 billion worth of deposits were withdrawn, a quarter of the bank’s total deposits. At noon on 10 March the regulators announced that the svb had failed.

It can be one time. SVB’s business—banking for techies—was unusual. Most of the clients were firms, with deposits in excess of $250,000 protected by the Federal Deposit Insurance Corporation (FDIC), a regulator. They faced losses if the bank failed. And SVB used the deposits to buy long-term bonds at the peak of the market. “Maybe someone assumed that a Silicon Valley bank without a transition would be a good candidate for failure,” says former Treasury Secretary Larry Summers. Nevertheless, withdrawal requests at other regional banks in the following days showed that “there was indeed substantial exposure”.

Hence the intervention of the authorities. Before markets reopened on March 13, the Federal Reserve and Treasury Department revealed that Signature Bank, a New York-based lender, had also failed. He announced two measures to prevent further collapse. Firstly, all depositors in svb and signature will be made whole and straight. Second, the Federal Reserve would create a new emergency-lending facility, the Bank Term Funding Program. This would allow banks to deposit high-quality assets such as Treasuries or mortgage bonds backed by government agencies, in exchange for cash advances of the asset’s face value, rather than its market value. The banks that had loaded onto the failed bonds would thus be protected from the fate of the SVB.

These events raise deep questions about America’s banking system. The post-financial crisis regulations were believed to have drained banks of capital, pumped up their cash buffers and limited the risks they were able to take. The Fed had the tools it needed to ensure that solvent institutions remained in business. Crucially, it is a lender of last resort, able to swap cash for good collateral at a penalty rate in its “discount window”. Acting as the lender of last resort is one of the most important functions of any central bank. As Walter Bagehot, a former editor of The Economist, wrote in “Lombard Street” 150 years ago, the job of a central bank is “to lend to every kind of existing security, or every kind of panic, on which money is usually based.” on and is usually lent.” , He “can’t save the bank; But if this does not happen, then nothing will be able to save.

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The Fed and Treasury interventions were of the kind that would be expected in a crisis. He fundamentally reshaped America’s financial structure. Yet at first glance the problem appeared to be poor risk management at a single bank. “Either it was an indecisive reaction, or there is too much rot in the US banking system beyond what we can even know about confidential supervisory information,” says Peter Conti-Brown, a financial historian at the University of Pennsylvania. So which one is it?

To assess the prospects, it is important to understand how changes in interest rates affect financial institutions. A bank’s balance sheet is a mirror image of its customers. This is money owed to the depositors. The people who owe the debt are its assets. By early 2022, when rates were near zero, US banks held $ trillion in assets. Of this, about $3.4 trillion was cash to repay depositors. Some $6trn was in securities, mostly Treasuries or mortgage-backed bonds. Another $11.2trn was in debt. America’s banks financed these assets with a huge deposit base worth $19 trillion, about half of which was insured by the FDIC and half of which was uninsured. To protect against losses on their assets, banks held $2 trillion of “tier-one equity” of the highest quality.

Then the interest rates increased to 4.5%. The decline of SVB has drawn attention to the fact that the value of banks’ portfolios has fallen as a result of rate hikes, and this hit is not reflected on the balance sheet. The FDIC reports that, overall, US have $620bn in unrealized mark-to-market losses. It is possible, as many have done, to compare these losses with those of equity banks and feel a sense of bewilderment. A 10% hit to the overall bond portfolio, if realised, would wipe out more than a quarter of the banks’ equity. The financial system may have been well capitalized a year ago, so the argument goes, but a portion of this capitalization has been taken out by higher rates.


This practice becomes even more dangerous when other assets are adjusted for higher rates, as Erica Jiang of the University of Southern California and co-authors do. For example, there is no real economic difference between a ten-year bond with a 2% coupon and a ten-year loan with a 2% interest rate. If the value of the bond has fallen by 15% then the value of the loan has also fallen. Some assets will be floating-rate loans, where the rate moves in line with market rates. Helpfully, the data the researchers compiled split loans into those with fixed and floating rates. This allows the authors to analyze only fixed-rate loans. Result? Bank assets would be $2 trillion less than reported—enough to wipe out all equity in the US banking system. While some of this risk can be hedged, it is costly to do so and banks are unlikely to do much of it.

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But as Ms. Jiang and co-authors point out, there is a problem halting the analysis here: The value of the offsetting deposit base has not even been reevaluated. And it’s worth a lot more than it was a year ago. generally do not make payments on deposits at all. These are also quite sticky, as depositors keep money in checking accounts for years. Meanwhile, the ten-year zero-coupon bond has fallen in price by about 20% since the beginning of 2022, due to rising rates. effectively providing a low-cost deposit base, which is now 20% higher than last year – more than enough to offset losses on bank assets.

So the true risk for a bank depends on both deposits and depositor behavior. When rates rise, customers can move their cash to money-market or high-yield savings accounts. This increases the cost of bank funding, although generally not by much. Sometimes—if a bank experiences severe difficulties—deposits can disappear overnight, as the SVB discovered disastrously. Banks with large, stable, low-cost deposits don’t need to worry as much about the mark-to-market value of their assets. In contrast, banks with flighty deposits make a lot. As Huw van Steinis of Oliver Wyman, a consultancy, says: “Paper losses become real losses only when they crystallize.”

How many banks have loaded up on securities, or made too many fixed-rate loans, and been uncomfortably exposed to deposit flight? Insured deposits are the most reliable as they are safe if something goes wrong. So Ms. Jiang and co-authors turned their attention to uninsured cash. They found that if half of such deposits were withdrawn, the remaining assets and equity of the 190 US banks would not be sufficient to cover their remaining deposits. These banks currently hold $300bn in insured deposits.

The new ability to swap assets at face value under the bank term funding program should at least make it easier for banks to pay depositors. But even this is only a temporary solution. This in itself is a confidence move for the Fed’s new facility. This program will support struggling banks only as long as depositors think so. Lending through the facility is done at a market rate of approximately 4.5%. This means that if a bank earns less than the interest income it earns on its assets — and its low-cost deposits go away — the institution will die a slow death from quarterly net-interest income losses, rather than a quick one brought on by Went. Bank run.


That’s why Larry Fink, boss of large asset management firm BlackRock, has warned of a “slow-rolling crisis.” He expects this will include “more seizures and shutdowns”. That high interest rates exposed the asset-liability mismatch that SVB has fallen into is, he admits, “the price we’re paying for decades of easy money”. UPN’s Mr. Conti-Brown points out that there are historical parallels, the most obvious being the bank crashes that escalated in the 1980s as Paul Volcker, the Fed chairman at the time, raised rates.

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Higher rates have previously exposed problems in bond portfolios, as the markets show in real time how the value of these assets falls when rates rise. But bonds aren’t the only asset that carries a risk when policy changes. “The difference between interest-rate risk and credit risk can be quite subtle,” says Mr. Conti-Brown, “because rising rates will eventually put pressure on borrowers as well.” The first banks to fail in the 1980s were those where asset values ​​fell alongside rising rates – but the crisis also eventually exposed bad assets within America’s “savings”, specialist consumer banks. Thus pessimists worry that banks are now going to fail due to higher rates, the first domino to fall.

The upshot of all this is that the banking system is far more fragile than regulators, investors and possibly bankers themselves realized prior to last week. It is clear that smaller banks with uninsured deposits will need to raise more capital soon. Torsten Slok of Apollo, a private-equity firm, points out that a third of the assets in the US banking system are held by banks smaller than SVB. All of them will now focus on lending to try to shore up their balance-sheets.

Medium-sized banks can be too big to fail, a lesson regulators should learn from SVB. The episode has also changed other parables of post-crisis finance. “Investors after 2008 thought deposits were safe, and funding in the market was risky. They also thought Treasuries were safe and debt was risky,” says Angel Ubaid of Citadel, a hedge fund. “After the crisis All the rule books were written on that basis. Now the reverse seems to be the case.” However, one pattern persists: problems in the financial system never emerge from the most closely watched places.

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