Cracks in the Banking System

There is a crisis brewing in the US banking system, but this new crisis is very different from 2008. Historically, banks struggled or failed when their loans or investments went bad, when they lent money without proper lending standards or invested poorly, resulting in loans that went unpaid or investments that lost money. Of course, the 2008 crisis comes to mind, when banks lent or invested in mortgage loans with poor underwriting standards and crashed under the weight of unpaid mortgages across the country. In contrast, today’s banking crisis has little to do with the loans, or even the underlying investments in the banks. Today’s banking crisis is due to depositors leaving banks for higher interest rates elsewhere. Since loans are committed long-term and deposits must be paid on demand, slowly shrinking deposits can result in liquidity problems, and can become a bank run if news gets out that a bank is running low on cash.

The seeds of the current crisis were sown in the dramatic increases in the Fed Funds rate over the past year. The Fed’s interest rate changes drove short-term interest rates higher, resulting in T-bill and Money Market rates ranging from 4% to 5%. With such attractive rates, bank customers with large cash deposits began moving funds out of savings accounts and directly into treasury securities. Essentially, bank savings accounts were no longer competitive.

As depositors began to pull funds, bank reserves began to drop, becoming a slow-motion bank run. The slow-motion bank run became a lightning-fast bank run at Silicon Valley Bank when Silicon Valley Bank reached for more cash by selling some of their long-term holdings, and depositors became worried. A similar story has played out at Silvergate and Signature bank (with the addition of some bad Cryptocurrency investments), and more recently at First Republic Bank. These four banks were particularly at risk since they were boutique business banks, catering to large depositors who needed high service levels. Since these large depositors were above the FDIC limit of $250,000, they quickly moved their funds out at the hint of any trouble.

The Federal Reserve has responded with a Bank Term Funding Program, which provides loans up to one year to banks, dependent upon the pledge of the bank’s underlying government bond holdings. The goal of the fund is to provide liquidity, providing much needed cash to fund withdrawals, while avoiding a forced sale of the bank’s holdings. We will see whether the program is enough to calm down depositors and stabilize the system.

This new crisis is both better and worse than 2008. It is better in that the underlying loans at the banks, for the most part, are paying. It is worse in that there is no easy answer out of the current problem. Regional banks are simply not able to compete in the current environment and are losing customers. No one wants to put money into a bank and worry about whether the money is safe.

To make matters worse, the FDIC, the Federal Reserve, and the Treasury are picking winners and losers by guaranteeing the deposits of the larger, ‘systemically critical’ banks, but allowing, or threatening to allow, smaller banks to go under. Large depositors with deposits above the FDIC limit have a clear incentive to move to the larger banks. That appears to be happening and makes the situation worse for the smaller banks. Losing these banks could result in a significant hit to the economy since they often serve small businesses that value a local relationship. It is likely that, even those banks that survive will be smaller and less profitable going forward.