March 17, 2023
It isn’t every day that 11 giant banks converge to deposit $30 billion into a smaller one to keep it afloat. But these are far from normal times in banking, as fallout from the failure of Silicon Valley Bank, known as SVB, leaves the sector in a state of turmoil, if not outright crisis.
The company getting that $30 billion, First Republic Bank, has turned into a kind of firewall against further stress to the banking system from SVB’s collapse. First Republic’s stock lost more than 60% in the past week and its credit was downgraded to junk. The bank’s wealthy clients and investment companies are largely uninsured depositors.
After SVB went belly up, along with Signature Bank of New York, First Republic was at risk of a run that could also have shut it down, further destabilizing the sector. For companies such as JPMorgan Chase, Citigroup, Wells Fargo, and Bank of America (BAC), the cost of a bailing out First Republic appears to have been far lower than letting it fail and suffering more damage to their business and financial positions.
“This show of support by a group of large banks is most welcome, and demonstrates the resilience of the banking system,” the FDIC said in a joint statement with the Federal Reserve, Treasury Department, and Office of the Comptroller of the Currency or OCC.
To say it’s most welcome is an understatement. While this isn’t a full-blown crisis, signs of stress have popped up in new and unexpected ways lately, exposing regulatory lapses, holes in bank balance sheets, and worries that regional banks—a crucial financial artery for small business, real estate, and the broader economy—face far more trouble than previously thought.
One way this episode differs from past crises is that it’s happening a level below the “too big to fail” giants. Rules in place since 2008, including stiffer capital requirements and mandatory stress tests, have shored up the so-called Tier 1 banks like JPMorgan, Citigroup, and BofA. Those banks now have plenty of capital and liquidity with which to make loans, absorb losses, and shore up banks like First Republic.
Another key difference: the trigger for this turmoil wasn’t a credit crisis. There’s no talk of subprime mortgages going bust or esoteric financial instruments blowing up. Rather, regional banks have been hit by falling prices for securities considered the safest in the world: U.S. Treasury bonds and government-backed mortgage securities.
Some banks bought massive amounts of these bonds as deposits swelled, figuring they were risk free. What everyone seemed to have missed is that these securities would burn holes in balance sheets as interest rates soared, pressuring bond prices. As the Federal Reserve hiked rates at the fastest pace in 40 years, unrealized losses piled up, reaching $620 billion as of December, according to the FDIC.
Those losses wouldn’t be a problem if banks could hold the bonds to maturity and wait for them to pay off at 100 cents on the dollar. That’s working for the big banks, but it’s not what happened at SVB, which faced a liquidity crunch after disclosing unexpected losses on its bond portfolio. That triggered a run on its largely uninsured deposits, stoking fears that other regional banks with a similar deposit profile would go down the same way.
Emergency measures from the Fed and the Biden administration have quelled the panic for now. The FDIC also calmed the market with promises to cover uninsured deposits of the failed banks, regardless of the standard $250,000 cap. First Republic’s apparent lifeline sent its stock soaring and lifted stocks across the regional spectrum, including hard-hit names such as Western Alliance Bancorp, East West Bancorp, and PacWest Bancorp.
Still, the turmoil will have ramifications. U.S. regulators are under fire for creating a “systemic risk” exception to bail out uninsured depositors at SVB and Signature, setting a dangerous precedent by rescuing their customers and raising questions about whether other relatively small banks would receive similar backstops if they failed. The regionals didn’t have to meet the same stringent standards on capital, liquidity, and asset safety imposed on the biggest banks after 2008, highlighting gaps in the rules.
The episode is also accelerating a dual class banking system. On one side is the privileged class of Tier 1 banks that are implicitly backed by the government as “too big to fail.” Just below them are regional and other banks with under $250 billion in assets; though the government says it will make uninsured depositors whole this time around, none can count on a rescue in the future—especially now that the Biden administration is likely to face a political storm over bending the rules for SVB and Signature.
One looming worry: Regionals are critical in specialized banking like commercial real estate and lending in specific regions; if those activities dry up, or deposits bleed out to the big banks, the economy could take hits, analyst Jim Bianco, president of Bianco Research, wrote in a note this past week.
Granted, it was a matter of time before something broke in banking due to the pressure from rate hikes. “Conditions were made ripe for mistakes and a shock,” says Thomas Hoenig, former president of the Federal Reserve Bank of Kansas City. Hoenig says regulators failed to heed lessons from Banking 101, namely that “risk-free” securities can pose steep losses in a rising rate climate. “The regulators weren’t paying attention to how fast rates were rising,” he says.
SVB, the 16th largest U.S. bank before it failed, illustrates how a solid-looking lender can fail in a flash. The bank had a thriving book of loans, owned a respected equity research shop, and appeared solidly profitable. But its securities portfolio consisted largely of government bonds that got hammered, leading to a warp-speed liquidity crisis. After SVB disclosed a nearly $2 billion loss on the bonds on March 8, depositors panicked the next day, clamoring to withdraw $42 billion. The bank almost immediately shut down with a $15 billion funding hole.
SVB, like First Republic, was also vulnerable because of its deposit base. Both banks focus largely on wealthy clients, investment firms, and commercial banking, leaving most of their accounts uninsured by the FDIC. At SVB, $151 billion out of $173 billion in total deposits was uninsured and prone to flee at signs of trouble. First Republic also saw massive deposit outflows in a short span, leaving it vulnerable to a business-ending run.
How to stop this from happening again? Whether the Fed, OCC, and the FDIC have enough tools to prevent another systemic crisis is now likely to be debated in Congress. Government investigations are starting, looking into how SVB collapsed so quickly and whether laws were broken.
Some economists would like to see the Fed’s stress tests pay closer attention to interest-rate risk, which hasn’t been frequently assessed because regulators expected banks to face more trouble from an economic hit. Regulators could also keep closer tabs on signs of stress arising from a mix of a bank’s accelerated asset growth with an unstable deposit base. “When I was in supervision, we looked at accelerated growth, that was a red flag,” says Hoenig.
With social media and messaging apps amplifying runs, regulators should be positioned to react faster, says Saule Omarova, a Cornell law professor who was President Biden’s nominee to run the OCC. “This is what SVB shows: once things start unraveling, because of this speed and scale in financial markets, it’s very difficult to stop the spiraling,” she says.
Other experts suggest revisiting changes to banking rules that reduced scrutiny of smaller banks. Several rules put in place after the 2008 crisis—including stiffer liquidity requirements and stress tests for banks with more than $50 billion in assets—were weakened by Congress and the Fed around 2018. SVB was one of several regionals that lobbied for the changes. Banks below $250 billion in assets now get a pass on stress tests. Liquidity requirements for regionals were also weakened and they are no longer required to file so-called living wills, or an orderly resolution plan in the event of a failure.
“Tools were taken away by Congress and given up by the Fed voluntarily, so it’s not surprising that supervisory teams looking at SVB didn’t notice the right things,” says Omarova. Stress testing for liquidity would have “immediately shown” problems on SVB’s balance sheet, she adds. “The risk wasn’t a hidden secret that only people with X-ray vision could have seen.”
Hoenig argues that banks would be stronger if regulators scrapped risk-weighted capital standards, which enable them to reduce the amount of assets they have to measure capital against. For example, government debt securities are given a risk weight of nearly zero percent on the balance sheet; had they been listed at par value, or 100%, it would have shown that capital available to absorb losses was less than what was reported under the risk-weighted measure. SVB, for instance, had a risk-weighted capital ratio of 16%, which looked ample. “When you adjust that ratio to include government bonds, that number falls dramatically and you see this thing wasn’t as well capitalized as you might have thought,” he says.
Some experts say it’s time to scrap the $250,000 insurance deposit limit. Robert Hockett, a Cornell law professor, recently proposed draft legislation, now under consideration in the House Financial Services Committee, that would extend deposit insurance to all accounts in full. The FDIC would establish a fee schedule to cover the premiums and banks could pass along some of the cost to depositors, he says, similar to how insurance is priced for cars and houses.
“We have to make banks safe and a $250,000 cap won’t do, because it is chump change,” he says. “The alternative is [JPMorgan CEO] Jamie Dimon buys everything or the shadow banking sector gets everything, and we don’t want either of those outcomes.”
Universal deposit insurance, however, has potential problems that would need to be addressed. The government shouldn’t explicitly backstop the liability side of the balance sheet without also focusing on risks of the asset side, says Omarova. Without controls, banks might make even riskier bets, and that could ultimately undermine public trust in banks. “You would put moral hazard on steroids,” she says. “It would be the worst of both worlds.”
This article was originally published in Barron’s on March 17, 2023, and was written by Daren Fonda.
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