The previous month was marked by the crisis of U.S. regional banks, which are crucial for the growth and stability of the U.S. economy. They contribute 40% of lending in the U.S. market and account for 30% of U.S. bank-held assets. In the span of two months, the third (SVB) and second largest (First Republic) banks both failed. Since 2008’s fallout of Washington Mutual, when skepticism arose over our banking system, there has not been such a dramatic ending for any U.S. bank firm. Should we now fear the contagion of this U.S. regional banking crisis? What is the looming risk of the U.S. regional banking industry?
We start our tale of the U.S. regional bank crisis by pointing out the lack of diversification that contributed to banks’ own deaths. Diversification is a wise financial decision that expands the doors of opportunity. The saying “Don’t put all your eggs in one basket” resonated especially strongly in March 2023. To put things in perspective, SVB became a phenomenal bank by specializing in venture capitalist fund activities and tech companies. During its peak at the end of 2022, it reached 200 billion dollars in assets. However, the overall economic condition shifted from boom to bust in 2022, and many tech companies endured financial hardship. The unhealthy situation of tech companies meant that SVB now existed in a very tumultuous time. The firm started to experience an unprecedented withdrawal of deposits from VC funds and tech companies that could no longer be covered by its assets. This characteristic of SVB was shared by Silver Gate and Signature Bank, both of which relied heavily on the success of crypto industries.
The tragedy experienced by SVB and First Republic reminds us of two basic rules of finance that should be cemented in the minds of all managers. First, diversification is fundamental. Second, managers should be aware of interest rate risks
The collapse of midsize U.S. banks was fuelled by a rapid change in interest rates. Central bankers around the world decided in 2022 to hike interest rates to tackle inflation. For banks, hiking interest rates can be beneficial because they can improve their net interest margins by charging more interest to borrowers and continuing to pay less interest to depositors. On the flip side, tightening monetary policy has the power to lead to a banking crisis, undermining financial stability, as assets held by banks for long-term maturity such as bonds fall in price as interest rates increase. This second situation is what caused the unfortunate situation of U.S. regional banks in 2023. As Greg McBride, the chief financial analyst at Bankrate, said: “When interest rates go up at the sharpest rate in 40 years, bad decisions are going to be exposed.” The declining price of assets previously held to maturity, combined with the gigantic wave of deposit withdrawals, triggered a banking crisis.
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The failure of some U.S. regional banks resulted in an overwhelmingly stressful environment. At first glance, U.S major banks are performing very well in this tightening monetary environment, as the first quarter of 2023 was benign, even sensational for these institutions. For example, City Group shares increased by 4.8%. What is the situation of the general banking system under this contractionary monetary policy? According to a study published by the Stanford Institute for Economic Policy titled “Monetary Tightening and U.S bank fragility in 2023: Mark-to-Market Losses and Uninsured Depositors Runs?” U.S. banking system is two trillion dollars lower than its book value. This situation has triggered two interrelated concerns: the solvency of banks and the potential run of uninsured depositors. On the other hand, interest hikes create a tradeoff between deposits and other assets for customers. This reality further affects the stability of deposits, as banks have incentives to raise the interest, they offer on their deposits in a distressing monetary tightening environment. Money market funds emerged as an alternative to provide safety and promise high yields in this year of uncertainty. Weekly data released by the Fed in March 2023 illustrated that deposits in the banking system fell by 53 billion dollars, all while the U.S. money market was overheating by a growth of 121 billion. The disaster encountered by banks can create a highly challenging environment for some industries. The debacle of these firms can also hamper venture capital and start-up activities. According to Juanita Gonzalez Uribe, an associate professor of finance at the London School of Economics, venture debt for venture-backed companies has made up 15% of total VC investment since 2010.
The tragedy experienced by SVB and First Republic reminds us of two basic rules of finance that should be cemented in the minds of all managers. First, diversification is fundamental. Second, managers should be aware of interest rate risks, as high interest may create distress for the financial sector. As Bill Ackman, founder of Pershing Square Capital, has said: “SVB’s senior management made a basic mistake. They invested short-term deposits in longer-term, fixed-rate assets. Thereafter short-term rates went up and a bank run ensued. Senior management screwed up and they should lose their job”.
Bangoura is a CPA student at Toronto metropolitan university.