What's Going on in the Banking System?

Matt Wright, CFA® |

The bigger picture in the banking industry:

  • Banks are allowed to hold a “bucket” of certain debt securities on their balance sheets and don’t have to value them at current market prices as long as they intend to hold them to maturity.
  • With the Federal Reserve’s aggressive interest rate hiking campaign over the past year to combat inflation, many banks have substantial unrealized losses in this bucket.
    • As long as the bank remains well capitalized with other liquid reserves, it can continue to hold these securities until they mature without recognizing losses in the short term.
    • However, if the bank is forced to start selling these securities for any reason, they have to recognize the losses on their balance sheet, which can suddenly create a large capital deficit.

The smaller picture of the failed banks:

  • The three banks that have failed in recent days all had a common factor: A depositor base subject to mass withdrawal risk. Silvergate and Signature Bank both catered to the cryptocurrency industry, while Silicon Valley Bank primarily worked with start-up businesses which tend to deplete cash in their early growth years. These customer bases have been under considerable pressure lately with numerous high profile implosions of crypto firms in 2022 and a slowdown in venture capital business as interest rates have moved higher.
  • Silvergate chose to voluntarily liquidate its business after seeing substantial deposit withdrawals since last summer’s collapse of crypto broker FTX., but depositors were not expected to be at risk. Signature Bank and Silicon Valley Bank, however, were taken over by the FDIC when they became insolvent.
  • A key point is that a substantial amount of these latter banks’ deposits was above the FDIC’s $250,000 per account owner limit. For example, some of Silicon Valley Bank’s corporate clients had hundreds of millions of dollars on deposit, so with only $250,000 protected by the FDIC, they faced substantial potential losses if the bank collapsed.
  • The combination of depositor withdrawals and unrealized losses becoming realized resulted in rapid depletion of the banks’ capital and liquidity levels. As the broad depositor base came to realize this, these banks became subject to withdrawal runs as clients sought to remove their uninsured deposits as quickly as possible. This creates a feedback loop whereby the banks would have to
    continue selling assets at losses to meet withdrawal demands, deepening the capital deficit even further. When the banks reach a point of insolvency, the FDIC steps in to protect the insured deposit base.

Regulators’ extraordinary measures:

  • Due to the high level of corporate uninsured deposits, there were concerns that many companies would not be able to make payroll, pay vendors/suppliers, etc. without access to their deposits, which could hurt the broader economy. The FDIC, Treasury, and Federal Reserve worked together and established new programs to protect all of these banks’ depositors (not just those insured under
    $250,000) and create additional liquidity for other banks that may see unanticipated withdrawals.

Expected Economic impacts:

  • Most large banks have diversified depositor bases and ample capital and liquidity cushions, making runs on deposits unlikely. There are a select number of banks that have above average risk, but the regulators’ actions were aimed to reduce their risk of failure. Should they become insolvent in the near term anyway, uninsured depositors would presumably be protected as in the other cases.
  • Nonetheless, bank credit throughout the economy will likely be somewhat ttighter than previously assumed, reducing economic growth projections modestly.
  • Expectations for the pace of further Federal Reserve rate hikes have declined sharply. While there still may be some rate hikes to come, the market views the pressures on the banking system and the resulting economic softness as reasons to be less aggressive on that front.

What does it mean for you?

  • Regardless of the current potential protection for uninsured bank deposits, we would always recommend that individuals and businesses seek to keep deposit balances within the FDIC insured limits.
  • Do not abandon a long-term investment strategy.
    • History is filled with failures of previously prominent businesses, including plenty of banks.
    • The economy’s long-term growth faces periodic setbacks, but the upward march hasn’t stopped.
    • Yes, stock and bond markets will be volatile – they always have been! This alone is not a reason to avoid investing but certainly requires periods of patience.