Without a functioning banking system, our economy will fail.
Bank failures, bank rescues, and declining confidence in banks have dominated the news over the last few weeks. I cannot think of any issue that is more important right now. If banks falter and lending slows to a crawl, everyone will suffer.
What happened to Silicon Valley Bank, Signature Bank, and Silvergate Bank? How are these failures impacting other banks and the economy? In this issue, I will explain the following:
● How our banking system works
● What caused the three banks to fail
● How the Fed stepped in to protect depositors, help other banks, and retain confidence in the banking system
● How the economy is responding and how the future looks.
HOW OUR BANKING SYSTEM WORKS
When you deposit money in your bank, the bank will take a portion of your deposit and lend it out as car loans, mortgages, credit cards, and business loans. Your bank will be profitable if it collects more in interest payments on loans than the interest it pays out to depositors.
Holding a portion of deposits at the bank is known as fractional reserve banking. Typically, only 8% to 10% of bank funds need to be available for depositors’ withdrawals.
When banks need to borrow money to fund loans, pay withdrawals, pay debts, or meet other obligations, they have a couple of options.
One option is to borrow money from other banks and pay interest to those banks. The interest rate banks charge one another is based on a range set by the Federal Reserve Board of Governors. This is the Federal Funds Rate. The latest range was set on March 22, 2023 at 4.75% to 5.00%.
When the Fed announces a new Federal Funds Rate, it grabs headlines because the rates impact how easy or difficult it is for businesses and consumers to get loans. Rising interest rates slow down the economy and falling interest rates stimulate borrowing and purchasing.
As we have experienced, a sustained period of low interest rates drives up prices and causes inflation. Inflation in February 2023 was 6.04%. The Fed is mandated to control inflation and it has been raising rates to reduce inflation to its goal of 2%.
A second option for banks who need money and who cannot borrow from other banks is to get a loan directly from the Federal Reserve. This is known as the discount window and referred to as the “option of last resort,” because the bank is stigmatized and they pay a higher interest rate.
Banks are regulated at the state or national level. Regulators enforce interest rate limits, audit banks, and inspect them. National banks are regulated by the Office of the Comptroller of the Currency (OCC). The OCC regulates how much capital the bank must maintain, the quality of the assets, and liquidity. (Liquidity is how quickly an asset can be turned into cash.)
The 2008 financial crisis impacted the global financial system, caused several large Wall Street firms to fail, and triggered the Great Recession. While trillions of dollars of almost-worthless subprime mortgages were the smoking gun, the regulatory framework was also at fault. There were not adequate safeguards to prevent banks from failing or to protect consumers.
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act established higher capital requirements and oversight for banks with greater than $50B in assets. These banks were deemed “systemically important.” In 2018, the $50B limit was raised to $250B.
WHAT CAUSED THE THREE BANKS TO FAIL?
▸ Silicon Valley Bank (SVB) – Shut down on Friday, March 10. This was the 16th biggest bank in the US with $212B in assets and the second biggest bank failure in US history.
SVB catered its services mainly to startups and venture capital firms. Nearly half of venture-backed companies had deposits there. More than 90% of the depositors held over $250,000 in their account.
Banks have to manage risk and SVB did it poorly. Since the bank’s closure, the public learned that the Fed has been monitoring SVB for more than a year and that SVB had been repeatedly warned of its problems. Fed Chair Jerome Powell said, “Silicon Valley Bank management failed badly. They grew the bank very quickly. They exposed the bank to significant liquidity risk and interest-rate risk, and didn't hedge that risk. We now know that supervisors saw these risks and intervened.”
Here is what happened. In the last quarter of 2021, tens of billions in deposits were flowing into SVB. They used a lot of that money to purchase long-term treasurys and mortgage-backed securities. Treasurys are the safest investment because they are backed by the US government. At the time, 10-year treasurys were paying less than 1.5% interest.
Early 2022, the central bank began raising interest rates at the fastest pace since the 1980s. As interest rates on securities rose, many of SVB’s depositors sought higher interest rates. They were lured away by online banks, treasurys, and money market funds that offered attractive rates.
Also during this time, many startups were burning through cash and it was more difficult finding the next round of investors. SVB could not offer competitive rates and they were forced to pay out depositors. This required selling some of their long-term treasurys at a discount because the treasurys had not reached maturity. SVB also sold some of the home mortgages it issued to its customers. The jumbo mortgages were fixed at low interest rates and not guaranteed by Freddie Mac or Fannie Mae. Like long-term treasurys, these mortgages were also sold at a discount.
SVB tried to raise $2B by selling shares of stock. This “equity financing” effort failed and when news spread, the bank’s stock prices fell by 60%. Depositors started withdrawing funds and SVB scurried to sell its most valuable and liquid assets to meet depositors' requests. Fear spread quickly in the highly-networked VC community and on social media. A bank run was underway. SVB was shut down and taken over by the FDIC.
▸ SILVERGATE BANK – Shut down on March 8. This was one of two main banks for the crypto industry. It had $11B in assets.
Silvergate Bank was a traditional bank that embraced the crypto industry. It accepted deposits from crypto exchanges and traders. It also built a “payments network” that allowed customers to buy and sell crypto to one another with US dollars through their respective bank accounts. Crypto enthusiasts and crypto exchanges spoke glowingly of the bank.
When many crypto companies started to fail and cryptocurrencies dropped in value, Silvergate responded responsibly. During the bank run, Bloomberg columnist Matt Levine said, “Silvergate is having a real run on the bank! It has lost money, not by making dumb Bitcoin loans — the Bitcoin loans are fine — but by doing the normal business of banking, borrowing short (taking deposits from crypto firms) to lend long (buying Treasuries and munis). Silvergate’s assets are real boring normal stuff, and if its depositors had kept their money at Silvergate, its bonds would have matured with plenty of money to pay them back. Instead, the depositors demanded their money back all at once, and Silvergate had to dump its long-term assets at big losses to repay them.”
The bank run followed a warning to all banks by US regulators about crypto volatility. Also contributing to the Silvergate bank run were ongoing press releases and tweets from politicians vehemently opposed to crypto, such as Senator Elizabeth Warren. After the collapse, Warren said, “As the bank of choice for crypto, Silvergate Bank’s failure is disappointing, but predictable.”
▸ SIGNATURE BANK – Shut down on March 12. This bank had $110B in assets and was one of the biggest real estate lenders in the New York area. It also serviced crypto companies and exchanges.
Signature bank had close business relations with many of the top New York City apartment landlords. The bank, however, was looking to reduce its reliance on real estate and add other industries to its client roster. This was viewed as a hedge against the real estate market.
According to a Wall Street Journal article, Signature provided loans to heavy-equipment manufacturers, cab drivers, private-equity investors, and crypto businesses. Deposits from crypto companies helped the bank double deposits in two years. Early 2022, digital asset clients accounted for 27% of its deposits.
In November, 2022, the collapse of crypto exchange FTX caused Signature to lose billions in deposits. The bank started to disfavor crypto clients, including the largest crypto exchange, Binance. Other large crypto companies such as Circle, Coinbase, and Kraken started pulling funds from Signature.
Tweets by large depositors that they were leaving Signature following bank runs at Silvergate and Signature caused others to withdraw funds. The New York banking regulator, New York Department of Financial Services, placed the bank in receivership with the FDIC.
Signature board member and former US Congressman Barney Frank (co-sponsor of the Dodd-Frank legislation) said Signature may have been shut down because of its crypto depositors. Frank said the bank was solvent. In a Wall Street Journal opinion by The Editorial Board, “Reuters reported last week that the FDIC was requiring any buyer of Signature to give up all crypto business at the bank. The FDIC denied this.”
However, the denial seems disingenuous because the successor bank to Signature, Flagstar Bank, will not receive $4B related to digital-assets.The FDIC said it “estimates the cost of the failure of Signature Bank to its Deposit Insurance Fund to be approximately $2.5 billion.” If Flagstar had assumed the $4B in crypto deposits, there would be no need for the insurance fund to guarantee them.
HOW THE FED STEPPED IN TO PROTECT DEPOSITORS, HELP OTHER BANKS, AND RESTORE CONFIDENCE
▸ All Silicon Valley Bank and Signature Bank Depositors are Protected
The Federal government took decisive action to stop future bank runs. “We wanted to make sure that the problems at Silicon Valley Bank and Signature Bank didn't undermine confidence in the soundness of banks around the country,” Treasury Secretary Janet Yellen said. “We wanted to make sure that there wasn’t contagion that could affect other banks and their depositors.”
The Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) guaranteed the uninsured deposits at the failing banks. All depositors, including those with deposits greater than $250,000, would get their money. The money would be from the banking industry insurance fund, not taxpayers.
▸ Vulnerable Banks Given a Lifeline
Government relief was also offered to other banks who were vulnerable to a mass of a sudden exit of depositors. Yellen announced an emergency-lending program, the Bank Term Funding Program (BTFP).
The BTFP would provide loans up to one year to banks that offered specific types of collateral – US treasury securities and mortgage-backed security. The loan terms are much more attractive than what is offered through the Fed’s emergency discount window.
Here is how the BTFP works. If banks do not have access to funds to pay fleeing depositors, banks won’t have to sell the long-term bonds at a discount. Instead they get a loan for the face value of the bond, not the market value.
Bloomberg’s Matt Levine explains, “If you have $100 of long-term 1% bonds that are now worth $85, you can borrow $100 against them, meaning that you can use those $85 of bonds to pay out $100 of fleeing deposits. This is terrible for your profitability — pay 4.7% to the BTFP and get only 1% on the bonds, so you’re losing 3.7% per year — but it does mean that you don’t vanish over the weekend if deposits flee. Which means there’s not much reason for deposits to flee. So it’s fine.”
Critics of the program claim that it is “stimulative” by introducing liquidity into the marketplace. When the government provides funds to banks for distressed bonds, the government is essentially printing money. This is counter to the Fed’s efforts to reduce inflation.
Another criticism is that banks on the precipice who borrow from the Bank Term Funding Program can remain anonymous. Unlike the Fed’s discount window, there is no stigma in the marketplace. When a bank considers lending to another bank, it will now be more difficult for them to assess the risk. This will add stress to the banking system.
▸ Confidence Restored in Banks?
Here is what has happened since the Fed stepped in on March 13th:
March 15 – Credit Suisse borrowed $53.7B from the Swiss central bank to shore up its liquidity.
March 16 – First Republic Bank, the 14th biggest US bank, which was on the brink of collapse when it was rescued by 11 banks for $30B. The plan was reached during a call between Secretary Yellen and Jamie Dimond, CEO of JPMorgan Case.
March 19 – UBS takes over its top domestic rival Credit Suisse in a $3B mega merger.
March 21 – Treasury Secretary Janet Yellen said the federal government could step in to protect depositors at additional banks if regulators see a risk of a run on the banking system.
March 24 – Massive selloff in Deutsche Bank, Germany’s largest bank, is underway.
March 27 – First Citizens is buying large pieces of Silicon Valley Bank.
The losses suffered by Silicon Valley Bank and Signature Bank are not unique. All banks’ long-term assets, US treasurys and mortgage-backed securities, dropped in value when interest rates rose. As interest rates rise, the “unrealized losses” will grow. This will hurt their balance sheets if they are forced to sell the assets at a loss. This concern along with likelihood of greater scrutiny from bank regulators will drive banks to preserve capital and pull back on lending. We are entering a phase of credit tightening.
Federal Research Chair Powell said at last week’s press conference, “[W]e’re looking at what’s happening among the banks… Events of the last two weeks are likely to result in some tightening of credit conditions for households and businesses, and thereby weigh on demand, on the labor market, and on inflation. Such a tightening in financial conditions would work in the same direction as rate tightening.”
A New York Times article cited economists at Goldman Sachs who said that because lending conditions had already begun to tighten “due to widespread recession fears,” the recent stress in the banking sector was equivalent to a quarter- or half-point increase in rates. The economists added that “the risks are tilted toward a larger effect,” and raised the likelihood of a recession in the next 12 months.
Commercial real estate contributed $2.3T to the nation’s economy last year. If banks pull back in commercial real estate lending, construction activity will slow down. Reducing loans also means fewer packaged loans (commercial mortgage backed securities) for investors. In 2022, CMBS were over $72B. In 2023, it is down 78% compared to 2022. The industry has not recovered from the pandemic, high office building vacancies, and workers no longer going into offices Monday through Friday. A new wave of bank credit tightening targeted to the commercial real estate industry could propel the economy toward a recession.
In residential real estate, homebuyer demand is primarily driven by mortgage rates. The 30-year fixed rates have fallen since the recent bank runs. On March 9, Freddie Mac’s rate was 6.73% and on March 23, it was 6.42%. However, banks will likely tighten their mortgage lending standards.