On May 1, 2023, US regulators seized troubled First Republic Bank (FRB) and promptly sold all of its deposits and most of its assets to the country’s biggest bank, JPMorgan Chase, in a bid to stem further turmoil in the banking sector. Despite obtaining a $30 billion lifeline from 11 of the country’s largest banks in mid-March, the FRB failed.
Founded in 1985 and based in San Francisco, the FRB was the 14th largest US bank with total assets of $229 billion and total deposits of $104 billion as of April 13, 2023. First Republic was not a typical mid-sized American bank, as it offered wealth management and brokerage services almost exclusively to affluent clients. The FRB also gifted green umbrellas and served “freshly baked cookies” to its customers in its upscale branches.
Since early March, troubles have been brewing in the regional banking sector with the collapse of Silicon Valley Bank (SVB) and Signature Bank with astounding speed. The last two months witnessed three of the four largest bank failures in US history. First Republic, SVB, and Signature Bank are currently the second, third, and fourth largest bank failures in US history, respectively, after Washington Mutual, which went bust during the 2008 global financial crisis and was also acquired by JPMorgan. The three recently failed banks together held assets of $532 billion, surpassing the $526 billion (when adjusted for inflation) owned by the 25 banks that failed in 2008.
The current regional banking crisis was caused by a number of factors, including rapidly rising interest rates (resulting in large declines in the market value of Treasury bonds and government-backed mortgage securities held by regional banks), high levels of uninsured deposits, regulatory rollbacks, and lax supervision by the US Federal Reserve.
An unfolding crisis
The crisis started on March 8 when Silvergate Capital Corporation, a bank with a concentration on cryptocurrency, declared plans to voluntarily liquidate itself after suffering losses following the collapse of crypto exchange FTX. Two days later, US regulators shut down SVB, a well-known lender to technology start-ups and venture capital firms in the San Francisco Bay Area.
On March 12, New York regulators shut down Signature Bank, which was focused on cryptocurrency customers, in an effort to stem a burgeoning banking crisis sparked by the SVB’s failure. Soon after, First Republic Bank became the focus of the turmoil as panicked customers and investors feared it could be the next bank to fail.
The failed banks had several things in common: they grew quickly using short-term funding before collapsing; their assets were heavily invested in long-dated Treasury bonds and mortgage-backed securities that exposed them to large unrealised losses due to rising interest rates in 2022-23; and they had a large concentration of uninsured deposits and other short-term liabilities that could be withdrawn at a moment’s notice. The asset and liability duration mismatch made these institutions vulnerable to uninsured depositor runs. When uninsured depositors began withdrawing their deposits en masse that led to the failures of these banks.
Nowadays, thanks to online banking and mobile banking apps, it doesn’t take long to withdraw and transfer money from banks. On March 9, customers withdrew $42 billion in a single day from Silicon Valley Bank. The bank failed a day later. While what occurred at SVB was an old-fashioned bank run, the pace of the bank run fueled by social media was unprecedented. Patrick McHenry, the chair of the House Financial Services Committee, described SVB as “the first Twitter-fuelled bank run”.
As banking is a confidence game, US financial regulators feared that widespread bank runs and failures could pose potential systemic risks. They announced an array of measures, including guarantees on all bank deposits of failed institutions, the provision of emergency liquidity, and the swift resolution of troubled banks.
Silicon Valley Bank or SVB. Photo: Minh Nguyen/Wikimedia Commons, CC BY-SA 4.0
The worst is not yet over
Despite repeated assurances from the US financial regulators that the worst is over and that the banking system is “sound and resilient” after the resolution of the FRB, investor confidence in regional banks remains low. On May 4, shares of two regional banks, PacWest Bancorp and Western Alliance, tumbled 51% and 39%, respectively.
As the Fed has not yet decided to pause its rate hikes, regional banks will continue to face intense pressure from depositors and investors in the coming weeks. Moreover, the equity bases of regional banks are insufficient to sustain significant losses on their security holdings. Reduced deposits and increased funding costs are already hurting regional banks’ profitability and business models.
Another major concern is that the ongoing banking stress will quickly translate into a credit crunch. A severe credit crunch looms large as regional and other lenders have already tightened their lending standards, which will reduce credit availability. The impacts would be immediately felt by small businesses and low-income households, who rely primarily on such banks for credit.
Regional banks may lack brand recognition, but they play a vital role in providing credit to small businesses and the commercial real estate (CRE) sector in the US. They are the main source of financing for office buildings, shopping malls, apartment buildings, and related businesses, which are already struggling due to rising interest rates and the COVID-19 pandemic.
Higher interest rates and the resulting instability in the banking system will drive the US economy into recession sooner than expected. In the best-case scenario, even if there are no more bank runs in the future and confidence in the regional banking space is swiftly restored, its broader effects on the real economy and financial stability would be felt for years.
Missing the wood for the trees
Many banking experts have attributed regional bank failures to bad and irresponsible management decisions made by individual banks, which contributed to unbridled growth, poor risk controls, and over-reliance on uninsured deposits.
Undoubtedly, failed regional banks were poorly managed and had incompetent management teams. But it would be erroneous to solely blame the individual bank and its management for its failure. This is because we live in a highly interconnected financial world in which banks do not operate individually or in a vacuum. Banks are an integral part of a large financial system in which changes in monetary policy and the regulatory environment have a significant impact on their behaviour and business models.
As discussed in detail later, a substantial portion of the blame for the current banking crisis rests with the US Federal Reserve, which pursued ultra-easy to ultra-tight monetary policies in addition to poor supervision of failed banks.
It would also be incorrect to consider the failed banks as idiosyncratic cases that pose no systemic risk. Because of two factors: First, given the ongoing banking turbulence, it is premature to declare unequivocally that the runs on US regional banks have ended.
Second, many U.S. banks are sitting on massive unrealised losses due to rising interest rates. This renders them even more susceptible to bank runs and enhances the fragility of the entire banking system. Two recent academic papers put the total unrealised losses on US bank balance sheets between $1.7 trillion and $2 trillion at the end of 2022, only slightly less than the total equity capital of $2.2 trillion in the entire banking system. Uninsured depositors account for approximately $9 trillion in total bank liabilities, posing a significant systemic risk in the event of a bank run. Uninsured deposits are consumer deposits that exceed the FDIC’s deposit insurance limit of $250,000.
Even a partial bank run by uninsured depositors could suddenly force U.S. banks to liquidate their long-dated securities at a colossal loss to cover deposit withdrawals, rendering them bankrupt. According to a recent study, almost 190 US banks are at potential risk of collapse if only half of the uninsured depositors decide to withdraw their funds. “If uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk”, says the study.
Fed’s misjudgments
One of the most important factors contributing to the current US banking turmoil is the Fed’s single-minded focus on controlling inflation, which has led it to raise interest rates too high and too quickly over the past year.
Regional (and small) banks are facing a triple whammy of risks arising from the Fed’s monetary tightening: massive unrealized losses on long-dated securities; a large outflow of deposits to larger banks (deemed safer) and money market funds; and lower profits due to higher funding costs.
Since March 2022, the Fed has increased interest rates ten times in a row, the most aggressive rate rise regime since the 1980s. With the latest 0.25% hike announced on May 3, 2023, the Fed raised the federal funds rate from near zero in March 2022 to a range of 5% to 5.25%. The rate hike has been accompanied by quantitative tightening — a substantial reduction in the size of the Fed’s balance sheet.
The ongoing banking turmoil is primarily attributable to the Federal Reserve’s poor policy decisions. For far too long, the Fed pursued an ultra-loose monetary policy stance characterized by ultra-low interest rates and quantitative easing. During the COVID-19 pandemic too, regional banks received large deposit inflows, but loan demand from households and businesses was feeble. As a result, regional banks invested large sums of money into lower-risk, long-term US Treasury bonds and mortgage securities. These investments, however, were subject to interest rate risk, and there was a duration mismatch between banks’ assets and liabilities with long-dated securities and short-dated demandable deposits.
As the Fed began hiking interest rates in March 2022, the market value of long-dated bonds began to fall. Why? Because interest rates and bond prices are inversely related: bond prices fall when interest rates rise. Rising interest rates resulted in paper losses for regional banks that had invested in such long-dated bonds when interest rates were significantly lower. This would not be a concern in times of abundant liquidity if banks retained these bonds until maturity.
Higher interest rates prompted depositors to withdraw funds from regional banks in order to invest elsewhere in search of higher returns. To cover deposit withdrawals, regional banks were compelled to sell their long-term bonds prematurely at a loss. For example, Silicon Valley Bank suffered a loss of $1.8 billion after selling $21 billion worth of securities. After disclosing the loss to the public, the SVB attempted to raise new capital, but its efforts were not only ineffectual but also frightened many of its customers in the venture capital community about the bank’s potential liquidity problems.
Since 93% of SVB’s total deposits were uninsured, a panic spread through texts and social media by the venture capital community led to a rush on withdrawals and ultimately the bank’s failure. After the failure of SVB, Signature Bank’s depositors also panicked due to the bank’s high proportion of uninsured deposits.
One would expect the US Fed to be more vigilant about the impact of rate hikes on financial fragility, and there should be no tradeoff between price stability and financial stability, but it appears that the Fed is more focused on preserving price stability than financial stability.
US Federal Reserve Board Chair Jerome Powell. Photo: US Federal Reserve, Public domain
Regulatory rollbacks and lax oversight
Regulatory rollbacks by the US Congress and lax supervision of banks by the Federal Reserve also contributed to the ongoing crisis in the regional banking space.
The Trump administration partially weakened the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted to safeguard financial stability in the aftermath of the 2008 crisis. In a bipartisan vote in 2018, the US Congress amended the Dodd-Frank Act to considerably lower the number of banks subject to stringent regulatory requirements such as stronger capital and liquidity rules, comprehensive resolution plans (also known as “living wills”), rigorous stress testing, and other standards.
The amendments raised the threshold for enhanced regulatory standards from $50 billion to $250 billion. Silicon Valley Bank and Signature Bank were thus exempted from the new regulations.
Even though the amended legislation was supposedly aimed at lifting regulatory burdens put on small and medium-sized banks, 25 large banks (including Credit Suisse — which also failed in mid-March) operating in the U.S. got exemptions.
If these amendments were not introduced, arguably the recent bank failures might have been prevented or at least resolved more quickly and smoothly. For instance, if SVB, Signature Bank, and First Republic Bank had been subjected to living wills and rigorous stress tests, their potential risks arising from interest rate hikes and an over-reliance on uninsured deposits could have been identified and addressed earlier, thereby preventing their collapse.
Poor enforcement of existing banking rules under Randal K. Quarles, Vice Chair for Supervision at the Fed, was another contributory factor, as acknowledged in recent reports issued by the Federal Reserve, FDIC, and Government Accountability Office on the ongoing crisis.
The Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley points out that “under the direction of the Vice Chair for Supervision, supervisory practices shifted…staff approached supervisory messages, particularly supervisory findings and enforcement actions, with a need to accumulate more evidence than in the past, which contributed to delays and, in some cases, led staff not to take action”.
The Fed’s review and the FDIC’s report on supervision of Signature Bank highlight staffing shortages on their side, despite the fact that the banks they supervise have grown and become more complex.
Persistent vulnerabilities
In response to bank failures, the Fed swiftly unleashed liquidity through its traditional discount window and newly established Bank Term Funding Program, in addition to guaranteeing all deposits at failed banks.
While these measures have helped reduce liquidity strains and the potential risk of bank runs in the short term, they are insufficient to address some of the underlying vulnerabilities that could contribute to more stress in the regional banking sector. Among these are unrealized losses on existing assets, rising funding costs, and a deposit flight away from small and medium-sized banks to big banks.
There is more trouble ahead for small and regional banks if the Fed keeps raising interest rates and continues its quantitative tightening.
The Biden administration has proposed a range of potential improvements to bank regulation and oversight (including reversing rules that were rolled back in 2018), but these efforts will likely be thwarted by the Republican-controlled House of Representatives. In a divided Congress, the odds of raising the FDIC’s deposit insurance limit remain slim.
Bipartisan support for legislation may be restricted to recouping compensation from executives of failed banks and prohibiting bank executives from serving on the boards of regulatory and supervisory bodies, as was the case with SVB’s CEO, who was a member of the Federal Reserve Bank of San Francisco’s board of directors from January 2019 until the day the bank failed on March 10. Thus, big questions remain about the political support required to undertake substantial banking reforms aimed at preventing future bank failures.
In the era of social media and digital banking, rumours (whether true or false) can cause billions of dollars to be withdrawn from a bank of any size with a few mouse clicks or smartphone swipes. Digital bank runs are terrifyingly unpredictable and difficult to manage.
To conclude, the macro environment for vulnerable small and regional banks has considerably deteriorated in recent months, making it unclear when and how this crisis will end. The bottom line: the regional banking crisis in the United States is still not over.
Kavaljit Singh works with Madhyam, a policy research think-tank based in New Delhi.
