The Agony of Banks: Does the Current U.S. Regional Bank Crisis Equal Systematic Risk?

By Abdoulaye Bangoura, Toronto,

The previous month was marked by the crisis of U.S. regional banks, which are crucial for the growth and stability of the U.S. economy. They contribute 40% of lending in the U.S. market and account for 30% of U.S. bank-held assets. The recent turmoil that unfolded has given people a sense of insecurity and uncertainty, and some observers are wondering if we are back to living in a dark period of bank run and financial instability. In the span of two months, the third (SVB) and second largest (First Republic) banks both failed. Since 2008’s fallout of Washington Mutual, when skepticism arose over our banking system, there has not been such a dramatic ending for any U.S. bank firm. Should we now fear the contagion of this U.S. regional banking crisis? What is the looming risk of the U.S. regional banking industry? To answer these questions, we must first discuss the diversification issue that is shared by many midsize banks, then explain the soaring interest rates that have transformed the fortunes of many U.S. regional banks into catastrophic situations. Finally, we will examine the risk of contagion to the global economy.

US Regional Banks Face a Diversification Problem

We start our tale of the U.S. regional bank crisis by pointing out the lack of diversification that contributed to banks’ own deaths. Diversification is a wise financial decision that expands the doors of opportunity. The saying “Don’t put all your eggs in one basket” resonated especially strongly in March 2023.

Diversification in financial markets reduces risk since all assets, as well as all markets, are not perfectly correlated. This proverb is true not only for individual investors but also for corporations in the way they carry out their activities. The misadventure experienced by some U.S. regional banks is partly due to the concentration of their deposits. This strategy is a trap that works perfectly when the sector is flourishing but turns into nightmarish financial decision-making when the sector is on the brink of collapse. In other words, the lack of diversification is a mask that reveals a darker reality in the blink of an eye.

To put things in perspective, SVB became a phenomenal bank by specializing in venture capitalist fund activities and tech companies. This positioning enabled it to become a fortress of cash but later triggered its downfall. SVB enjoyed a fruitful tech sector era throughout 2021 and 2022, its balance sheet spiking. During its peak at the end of 2022, it reached 200 billion dollars in assets. However, the overall economic condition shifted from boom to bust in 2022, and many tech companies endured financial hardship. Tech company stock plummeted more than 30% in 2022, and many companies slashed their workforce. For example, in August 2022, Robinhood cut 23% of its workforce.

The unhealthy situation of tech companies meant that SVB now existed in a very tumultuous time. The firm started to experience an unprecedented withdrawal of deposits from VC funds and tech companies that could no longer be covered by its assets. Such an unprecedented situation eroded the firm’s assets because it was highly dependent on this one sector. SVB now held fewer than 38,000 corporate accounts and an insignificant number of individual deposits. This characteristic of SVB was shared by Silver Gate and Signature Bank, both of which relied heavily on the success of crypto industries. As with the story of SVB, these two banks are currently facing chaos thanks to the very industries that made them so powerful in the first place.

Soaring Interest Rates Have Spelled Doom for Some US Regional Banks

The collapse of midsize U.S. banks was fueled by a rapid change in interest rates. Central bankers around the world decided in 2022 to hike interest rates to tackle inflation. Good economic performance requires good management of inflation, as high inflation is generally toxic to the well-being of the general economy. Therefore, low inflation (around 2%) is perceived by policymakers as a necessity for a robust economy. In the words of William McChesney Martin, “Price stability is essential to sustainable growth.” The interest rate experienced a significant increase over the course of 2022, creating distressing side effects on the housing market, private sector spending, and employment. For banks, hiking interest rates can be beneficial because they can improve their net interest margins by charging more interest to borrowers and continuing to pay less interest to depositors.

For instance, JP Morgan and City Group reported earning 12.6 billion and 4.6 billion respectively in their first quarter. On the flip side, tightening monetary policy has the power to lead to a banking crisis, undermining financial stability, as assets held by banks for long-term maturity such as bonds fall in price as interest rates increase.

This second situation is what caused the unfortunate situation of U.S. regional banks in 2023. As Greg McBride, the chief financial analyst at Bankrate, said: “When interest rates go up at the sharpest rate in 40 years, bad decisions are going to be exposed.” The shocking change in the interest rate was not anticipated by the managers of those banks. If they had made prudent decisions by investing in assets free of default, enough safeguards would have been in place to protect their assets against the rise of interest rates.

For example, SVB held 91 billion dollars in treasury and mortgage-backed securities between 2020 and 2021. However, the market value for these assets plummeted to 21 billion due to the change in interest rates. First Republic endured the same hurdle even though its exposure to unrealized loss was lower than SVB’s (15% of its assets are HTM securities). The declining price of assets previously held to maturity, combined with the gigantic wave of deposit withdrawals, triggered a banking crisis.

Source: CNBC
2022 was the worst-ever year for US bonds. How to position your portfolio in 2023

The above chart portrays the chaotic decline in bond returns, mostly long-term bonds, due to the tightening monetary policy. Regional banks like SVB parked their money in these assets when the rate was low so they could increase their profits.

Major U.S Banks Performed Robustly, But the Overall Picture Tells a Story of Desperation

The failure of some U.S. regional banks resulted in an overwhelmingly stressful environment. At first glance, U.S major banks are performing very well in this tightening monetary environment, as the first quarter of 2023 was benign, even sensational for these institutions. City Group shares increased by 4.8%, and JP Morgan took advantage of the hiked interest rate by achieving a jump of 49% in its net interest margin. Overall, the S&P 500 bank index was up 3.5% after first quarter result publications. U.S. bank heavyweights are widely diversified in terms of customer base. This strategic position is an important tool to properly manage the situation encountered by Signature Bank or SVB, for example.

Moreover, major banks’ exposure to interest rates is insignificant. While banks like SVB had 43% of bonds held to maturity in its balance sheet, this asset doesn’t exceed 10% for many major U.S. bank balance sheets. What is the situation of the general banking system under this contractionary monetary policy? Tightening monetary policy in order to curb inflation hinders the ecosystem of the U.S. banking industry in 2023. According to a study published by the Stanford Institute for Economic Policy titled “Monetary Tightening and U.S bank fragility in 2023: Mark-to-Market Losses and Uninsured Depositors Runs?” America’s banks appear more vulnerable to the contractionary monetary policy.

The study reveals that the market value of the U.S. banking system is two trillion dollars lower than its book value. This situation has triggered two interrelated concerns: the solvency of banks and the potential run of uninsured depositors. The solvency issue arises from the inability of banks due to their asset losses to cover their liabilities. As the Fed declared war against inflation by raising the federal funds rate, assets held by banks plunged and, in some cases, became insufficient to cover banks’ liabilities (deposits). Thus far in 2023, all banks have experienced an average decrease of 10% in their mark-to-market asset values. Such an unpleasant situation makes uninsured depositors raise their eyebrows, as they are concerned about the likelihood of bank failure and the loss of their deposits. Uninsured deposits are not protected by the Federal Deposit Insurance Corporation (FDIC), and they account for more than 40% of all U.S. deposits. The fear of bank insolvency increases bank deposit run since the faith of customers in their banks’ stability vanishes. As raised interest rates disrupt bank assets, it becomes more rational for uninsured depositors to run.

A shocking statistic depicts this reality: in the recent interest hike environment, if all uninsured depositors were to withdraw their funds from U.S. banks, 1,619 banks would have negative insured deposit coverage, and the deposit insurance fund would experience a shortfall of 300 billion dollars. In this scenario, withdrawing one’s deposit would be a wise and beneficial decision, and the feasibility of this statistic exacerbates an apocalyptic ending for the banking system. According to the Stanford study’s authors, if just 10% of uninsured depositors decided to withdraw their money, 66 banks would fail. If that ratio goes up to 30%, the number of banks that would go bankrupt is 106. On the other hand, interest hikes create a tradeoff between deposits and other assets for customers.

This reality further affects the stability of deposits, as banks have incentives to raise the interest, they offer on their deposits in a distressing monetary tightening environment for the valuation of their assets. Money market funds emerged as an alternative to provide safety and promise high yields in this year of uncertainty. Weekly data released by the Fed in March 2023 illustrated that deposits in the banking system fell by 53 billion dollars, all while the U.S. money market was overheating by a growth of 121 billion.

Source: Financial Times
Flood of cash into US money market funds could add to banking strains

This chart shows the reverse trend that occurred in U.S. money markets since interest rates were hiked. The money market was underwater, but the tightening monetary policy created a condition of inflow of money since deposits seemed unsafe and unattractive in terms of yields.

The situation is even worse for regional banks that must compete with money market funds to retain their deposits and with big banks. The Fed’s same weekly data displayed the deposit flight from smaller banks to big banks. While smaller banks’ deposits bled with a loss of 109 billion, big banks enjoyed an influx of 120 billion. The disaster encountered by banks can create a highly challenging environment for some industries. The situation of commercial real estate can worsen since banks become averse to providing more credit in this new environment of high interest rates.

The debacle of these firms can also hamper venture capital and start-up activities. According to Juanita Gonzalez Uribe, an associate professor of finance at the London School of Economics, venture debt for venture-backed companies has made up 15% of total VC investment since 2010. The failure of some banks that entered the headlines underlines the profound disruption within the U.S. banking system since the Fed started its tightening policy. Banks are struggling with the new macroeconomic policy, and this obstacle can lead to recession through the reduction of lending channels to non-financial sectors.

Reflecting on the Tightening Monetary Policy and Its Big-Picture Impacts on U.S. Finances

The Fed plays an important role in the U.S. economy, and the purpose of its creation can be scrutinized through many lenses. Part of its duty is to fight inflation to create a healthy environment for sustainable employment and price stability. The role of the Fed nowadays is also to act as a shield against financial market instability. Observation of the current macroeconomic environment shows that the Fed is doing an outstanding job in fighting inflation, which shifted from 7% in June 2022 to 4.2% in March 2023, while banks are facing too much headwind. This dual situation has led some thinkers to challenge the Fed’s current paradigm, which is centered on bringing down inflation further. As the interest rate is now sitting between 5% and 5.25%, the Fed must meditate on the effects of its policy decision before creating further hikes if necessary. There is no clear-cut solution.

Some may argue that the Fed must emphasize cutting inflation and that the bankers are responsible for the mismatch of their assets and liabilities. My personal opinion is that it would be best to take a break in the hiking process or to hike rates at a slower pace than what we have seen during this last tightening cycle. A lesson we can learn from this cycle is that rapidly increasing rates endanger financial stability. With an unrealized loss of 2.2 trillion in the U.S. banking system and growing pressure to attract deposits, a rapid increase in the interest rate over the upcoming months will only erode the health of the financial system. For Luigi Zingales, a professor at the University of Chicago Booth School of Business, “The banking system can’t function with 4% rates” (Bloomberg Surveillance). JP Morgan CEO Jamie Dimon’s thoughts converged when he said on Bloomberg, “I think there needs to be humility on the part of regulators… OK, we were a little bit a part of the problem as opposed to just pointing fingers.”

The tragedy experienced by SVP and First Republic reminds us of two basic rules of finance that should be cemented in the minds of all managers. First, diversification is fundamental. Through this crisis, it has become apparent that relying heavily on any single customer base is a huge mistake for the banking system. Policymakers must oversee the diversification of bank clients and set a rule to reduce bank run. Second, managers should be aware of interest rate risks, as high interest may create distress for the financial sector. As Bill Ackman, founder of Pershing Square Capital, has said: “SVB’s senior management made a basic mistake. They invested short-term deposits in longer-term, fixed-rate assets. Thereafter short-term rates went up and a bank run ensued. Senior management screwed up and they should lose their jobs.”