Banking is a
confidence trick. Financial history is littered with runs, for the
straightforward reason that no bank can survive if enough depositors
want to be repaid at the same time. The trick, therefore, is to ensure
that customers never have cause to whisk away their cash. It is one that
bosses at Silicon Valley Bank (svb), formerly America’s 16th-largest lender, failed to perform at a crucial moment.
The fall of svb,
a 40-year-old bank set up to cater to the Bay Area tech scene, took
less than 40 hours. On March 8th the lender said it would issue more
than $2bn of equity capital, in part to cover bond losses. This prompted
scrutiny of its balance-sheet, which revealed around half its assets
were long-dated bonds, and many were underwater. In response, deposits
worth $42bn were withdrawn, a quarter of the bank’s total. At noon on
March 10th regulators declared that svb had failed.
It might have been a one-off. svb’s
business—banking for techies—was unusual. Most clients were firms,
holding in excess of the $250,000 protected by the Federal Deposit
Insurance Corporation (fdic), a regulator. If the bank failed they faced losses. And svb
used deposits to buy long-dated bonds at the peak of the market. “One
might have supposed that Silicon Valley Bank would be a good candidate
for failure without contagion,” says Larry Summers, a former treasury
secretary. Nevertheless, withdrawal requests at other regional banks in
the following days showed “there was in fact substantial contagion”.
Hence
the authorities’ intervention. Before markets reopened on March 13th,
the Federal Reserve and the Treasury Department revealed that Signature
Bank, a lender based in New York, had also failed. They announced two
measures to guard against more collapses. First, all depositors in svb and
Signature would be made whole, and straightaway. Second, the Federal
Reserve would create a new emergency-lending facility, the Bank Term
Funding Programme. This would allow banks to deposit high-quality
assets, like Treasuries or mortgage bonds backed by government agencies,
in return for a cash advance worth the face value of the asset, rather
than its market value. Banks that had loaded up on bonds which had
fallen in price would thus be protected from svb’s fate.
Read more of this package
What’s wrong with the banks
The Fed smothers capitalism in an attempt to save it
For markets Silicon Valley Bank’s demise signals a painful new phase
What the loss of Silicon Valley Bank means for Silicon Valley
These
events raise profound questions about America’s banking system.
Post-financial-crisis regulations were supposed to have stuffed banks
with capital, pumped up their cash buffers and limited the risks they
were able to take. The Fed was meant to have the tools it needed to
ensure that solvent institutions remained in business. Critically, it is
a lender of last resort, able to swap cash for good collateral at a
penalty rate in its “discount window”. Acting as a lender of last resort
is one of any central bank’s most important functions. As Walter
Bagehot, a former editor of The Economist, wrote 150 years ago in
“Lombard Street”, a central bank’s job is “to lend in a panic on every
kind of current security, or every sort on which money is ordinarily and
usually lent.” That “may not save the bank; but if it do not, nothing
will save it.”
The Fed and Treasury’s
interventions were the sort which would be expected in a crisis. They
have fundamentally reshaped America’s financial architecture. Yet at
first glance the problem appeared to be poor risk management at a single
bank. “Either this was an indefensible overreaction, or there is much
more rot in the American banking system than those of us on the outside
of confidential supervisory information can even know,” says Peter
Conti-Brown, a financial historian at the University of Pennsylvania. So
which is it?
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To
assess the possibilities, it is important to understand how changes in
interest rates affect financial institutions. A bank’s balance-sheet is
the mirror image of its customers’. It owes depositors money. Loans
people owe it are its assets. At the beginning of 2022, when rates were
near zero, American banks held $24trn in assets. About $3.4trn of this
was cash on hand to repay depositors. Some $6trn was in securities,
mostly Treasuries or mortgage-backed bonds. A further $11.2trn was in
loans. America’s banks funded these assets with a vast deposit base,
worth $19trn, of which roughly half was insured by the fdic and half was not. To protect against losses on their assets, banks held $2trn of “tier-one equity”, of the highest quality.
Then interest rates leapt to 4.5%. svb’s
fall has drawn attention to the fact that the value of banks’
portfolios has fallen as a result of the rise in rates, and that this
hit has not been marked on balance-sheets. The fdic
reports that, in total, America’s financial institutions have $620bn in
unrealised mark-to-market losses. It is possible, as many have done, to
compare these losses with the equity banks hold and to feel a sense of
panic. In aggregate a 10% hit to bond portfolios would, if realised,
wipe out more than a quarter of banks’ equity. The financial system
might have been well-capitalised a year ago, so the argument goes, but a
chunk of this capitalisation has been taken out by higher rates.
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The
exercise becomes more alarming still when other assets are adjusted for
higher rates, as Erica Jiang of the University of Southern California
and co-authors have done. There is, for instance, no real economic
difference between a ten-year bond with a 2% coupon and a ten-year loan
with a fixed 2% interest rate. If the value of the bond has fallen by
15% so has the value of the loan. Some assets will be floating-rate
loans, where the rate rises with market rates. Helpfully, the data the
researchers compiled divides loans into those with fixed and floating
rates. This allows the authors to analyse only fixed-rate loans. The
result? Bank assets would be worth $2trn less than reported—enough to
wipe out all equity in the American banking system. Although some of
this risk could be hedged, doing so is expensive and banks are unlikely
to have done much of it.
But as Ms
Jiang and co-authors point out, there is a problem with stopping the
analysis here: the value of the counterbalancing deposit base has not
also been re-evaluated. And it is much, much more valuable than it was a
year ago. Financial institutions typically pay nothing at all on
deposits. These are also pretty sticky, as depositors park money in
checking accounts for years on end. Meanwhile, thanks to rising rates,
the price of a ten-year zero-coupon bond has fallen by almost 20% since
early 2022. This implies the value of being able to borrow at 0% for ten
years, which is what a sticky, low-cost deposit base in effect
provides, is worth 20% more now than it was last year—more than enough
to offset losses on bank assets.
The
true risk to a bank therefore depends on both deposits and depositor
behaviour. When rates go up customers may move their cash into
money-market or high-yield savings accounts. This increases the cost of
bank funding, although typically not by all that much. Sometimes—if a
bank runs into severe difficulties—deposits can vanish overnight, as svb discovered
in ruinous fashion. Banks with big, sticky, low-cost deposits do not
need to worry much about the mark-to-market value of their assets. In
contrast, banks with flighty deposits very much do. As Huw van Steenis
of Oliver Wyman, a consultancy, notes: “Paper losses only become real
losses when crystallised.”
How many
banks have loaded up on securities, or made lots of fixed-rate loans,
and are uncomfortably exposed to flighty deposits? Insured deposits are
the stickiest because they are protected if things go wrong. So Ms Jiang
and co-authors looked at uninsured cash. They found that if half of
such deposits were to be withdrawn, the remaining assets and equity of
190 American banks would not be enough to cover the rest of their
deposits. These banks currently hold $300bn in insured deposits.
The
newfound ability to swap assets at face value, under the Bank Term
Funding Programme, at least makes it easier for banks to pay out
depositors. But even this is only a temporary solution. For the Fed’s
new facility is something of a confidence trick itself. The programme
will prop up struggling banks only so long as depositors think it will.
Borrowing through the facility is done at market rates of around 4.5%.
This means that if the interest income a bank earns on its assets is
below that—and its low-cost deposits leave—the institution will simply
die a slow death from quarterly net-interest income losses, rather than a
quick one brought about by a bank run.
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This
is why Larry Fink, boss of BlackRock, a big asset-management firm, has
warned of a “slow-rolling crisis”. He expects this to involve “more
seizures and shutdowns”. That high interest rates have exposed the kind
of asset-liability mismatch that felled svb is, he
reckons, a “price we’re paying for decades of easy money”. Mr
Conti-Brown of UPenn points out that there are historical parallels, the
most obvious being the bank casualties that mounted in the 1980s as
Paul Volcker, the Fed’s chairman at the time, raised rates.
Higher
rates have exposed problems in bond portfolios first, as markets show
in real-time how these assets fall in value when rates rise. But bonds
are not the only assets that carry risk when policy changes. “The
difference between interest-rate risk and credit risk can be quite
subtle,” notes Mr Conti-Brown, as rising rates will eventually put
pressure on borrowers, too. In the 1980s the first banks to fail were
those where asset values fell with rising rates—but the crisis also
exposed bad assets within America’s “thrifts”, specialist consumer
banks, in the end. Thus pessimists worry banks now failing because of
higher rates are just the first domino to collapse.
The
result of all this is that the banking system is far more fragile than
it was perceived to be—by regulators, investors and probably bankers
themselves—before the past 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 assets in
America’s banking system are held by banks smaller than svb. All of these will now tighten up lending to try to strengthen their balance-sheets.
That medium-sized banks can be too big to fail is one lesson regulators should learn from svb.
The episode has upended other parables of post-crisis finance as well.
“After 2008 investors thought deposits were safe, and market funding was
risky. They also thought Treasuries were safe and loans were risky,”
says Angel Ubide of Citadel, a hedge fund. “All of the post-crisis rule
books were written on that basis. Now the reverse looks to be the case.”
One parable remains intact, however. Problems in the financial system
never emerge from the most closely watched places. ■