What is Going on with our Banking System???
A new chapter in the history of American bank regulation began the night of Wednesday, March 8. That’s when Silicon Valley Bank revealed that the need to raise cash to meet customer withdrawals forced it to book $2 billion in losses on the sale of securities, leading it to look for more capital. Less than 48 hours later, regulators shut down the bank as it lacked sufficient liquidity to satisfy withdrawal demands. An incredible 96% of its deposits exceeded the FDIC insurance limit of $250,000 per depositor. Shockwaves rippled through the bank system. Clients asked us whether their banks were safe, even behemoth Chase.
Over the past 40 years, we’ve had the “Latin American debt crisis” in the mid-1980s, the “savings and loan crisis” in the late 1980s-early 1990s, the Global Financial Crisis in 2008-2009, and now this mini-crisis. Regulatory changes are made after each one, but we always end up back in the soup! Many blame this crisis on changes to bank regulations in 2019, but in fact there is plenty of blame to go around.
This is the first banking crisis I know of that doesn’t involve deteriorating credit quality, only liquidity and interest rates. And for that, you can largely thank the government. There is a consequence to leaving interest rates near zero past the point that was necessary. Even more gas was poured on the fire when the Federal Reserve was almost literally printing $1 trillion a year to buy Treasuries and mortgage-backed securities. Same goes for trillions of dollars of spending beyond the normal budget. The money in excess of what was needed to run the economy had to go somewhere, and it did – banks (and inflation)! They lent out some and stashed the rest in high-quality securities.
Everything was fine when interest rates were zero because no one had an incentive to move their money. As rates rose, banks could no longer pay zero to depositors but couldn’t get their money back from borrowers or securities without recognizing losses and harming their capital ratios. Higher interest rates reduce the value of loans and securities acquired at lower rates. The higher short-term rates rose, the greater the stress on the banking system until something finally broke.
The loosening of regulations also played some role, but not as much as the press suggests. Congress passed what is known as the Dodd-Frank Act in 2010 to raise capital standards after the banking system nearly melted down in 2008-2009 when loose lending standards led to a collapse of home prices. Dodd-Frank made other improvements focused on the largest banks, categorizing certain of them as “systemically important financial institutions” (SIFIs). Remember that term. One of the major shortcomings of Dodd-Frank was to treat all significant banks as if they were SIFIs. This led to calls to make a better distinction between the banks truly representing systemic risks and the rest of the field. The 2019 adjustments to Dodd-Frank eliminated stress tests for banks under $250 billion. Also, the asset level needed to trigger an additional regulatory burden was moved from $50 billion to $250 billion.
Even $250 billion sounds small when put in the context of Chase and Bank of America, both of which have assets in excess of $3 trillion. Silicon Valley Bank and Signature Bank eluded more stringent regulation because of the 2019 changes. So did over 2,000 others that didn’t fail.
Would the pre-2019 regulatory scrutiny have prevented the failure of the two banks? Not likely since regulators had been talking to Silicon Valley Bank for years about insufficient liquidity yet failed to take any action. Regulators should have been all over SVB after its assets doubled in one year and Signature Bank after its assets doubled in two years. Success should be celebrated, but that kind of growth is unnatural for a bank and could easily lead to sloppiness and mistakes. Both banks remained subject to the same liquidity requirements in effect prior to 2019, but that was not enough when 20% of Silicon Valley Bank’s deposits were withdrawn in a single day.
Regulators seemed to under-react to the most critical factor – a high level of uninsured deposits. Over 90% of deposits at Silicon Valley Bank and Signature Bank exceeded the FDIC threshold of $250,000 per depositor. When a bank fails, insured deposits are typically returned in a few business days plus a receipt for any uninsured amount. Remaining funds are returned to uninsured depositors as the failed bank’s assets are sold, but there is typically a 10%-15% loss on uninsured deposits. The prospect of loss is sufficient motivation for the wealthy and business customers to wire their money out of a shaky bank.
Lastly, there was a focus on large securities portfolios as a contributing factor to the two failures. There is nothing inherently wrong with securities, and the only negative is that securities can be readily valued and losses calculated, unlike with loans. But there isn’t a significant difference between buying a 3% mortgage-backed security and underwriting a 3% mortgage loan directly. Both result in unrecognized losses when interest rates rise. Some believe these losses should be immediately recognized on a bank’s balance sheet, but that would lead to large scale insolvencies whenever rates rise meaningfully.
One potential “remedy” is to increase deposit insurance, but I’d argue it is up to the wealthy and businesses to look after their own interests. After all, why should all bank customers be forced to bail out the shareholders of Roku whose Board and management had $450 million on deposit at SVB? But that is what indeed happened. Regulators designated SVB and Signature Bank as “systemically important” after they had already failed, triggering unlimited FDIC insurance. Depositors knew the rules, but bank regulators bailed them out anyway! Setting up clear rules and enforcing them consistently would help customers force banks to behave responsibly. Banks will likely need to hold a higher level of liquid assets, reducing their profitability and also leading to fewer customer perks.
The good news is that a run on all banks is impossible since the money has to go somewhere. There is not enough cash on hand at any bank to meet customer demands so the money must be moved electronically from one institution to another. The most important advice we can give is quite simple: don’t maintain a cash balance above $250,000 per depositor in any bank except SIFIs and Schwab accounts under our management.
Scott D. Horsburgh, CFA