The Banking Crisis Explained
Watch the explainer video here.
The US economy has been hit with a string of bank failures, and these bank failures have exposed some major problems at the core of the US financial system.
Emergency measures by the Federal Reserve and US Treasury were required to stop several ongoing bank runs that threatened the solvency of dozens of institutions.
These events have rattled consumer and investor confidence, leaving many wondering why these events happened, if more bank failures are on the way, and what the impact will be to the economy in 2023.
In this video, we’ll take a look at the root cause of the issues plaguing the US banking sector, explain why more institutions are likely to fail in the coming months and outline why these events will worsen the ongoing recessionary pressures in the economy.
In it’s most simple form, people put money in a bank, called deposits, and banks pay an interest rate on those deposits. Banks then either buy securities, like Treasury bonds, or make loans, like real estate, auto loans or credit card loans.
If the bank earns more interest on the securities and loans than it pays in interest, they earn money and are profitable.
However, if banks have to pay more interest on their deposits than they earn in interest, or if the loans they made went bad, then they lose money.
Silicon Valley Bank ran into a problem for some very unique reasons, so we’ll first address the specific issue, and then explain why there is actually a much more worrisome situation for all smaller US banks.
As mentioned, most banks are funded with deposits. In the United States, deposits under $250,000 are protected by the government, called insured deposits.
Deposits over $250,000 are not protected and subject to losses if a bank is insolvent. These are called uninsured deposits.
Insured or small deposits are considered very stable and not at risk of a bank run because they are protected. Uninsured deposits, however, do have risk so these deposits are less stable for a bank because they can leave at any moment.
The average US bank is funded with 63% insured deposits and 23% uninsured deposits. Silicon Valley Bank had an extremely high amount of uninsured deposits, with some reports saying that $13 billion was held by just 10 people.
So if just the right 10 people decided to pull their money out, the bank would have to sell assets to give the customers their money back.
Remember that the bank assets are mostly securities like Treasury bonds or loans.
Silicon Valley Bank had mostly securities like Treasury bonds and Mortgage Bonds, and the problem is that these bonds declined in value, 10%, 20% or even 30% from when the bank bought the bonds.
The Federal Reserve has raised interest rates at the fastest pace in decades. When interest rates rise, bond values decline. So the rapid rate increases caused losses on all securities portfolios putting some banks at risk if customers suddenly decided to pull their money out.
Well at Silicon Valley Bank, those few people did all take their money out and it became clear that if Silicon Valley Bank sold off all of it’s assets, since they were underwater, they wouldn’t have enough money to give customers their money back. They were insolvent.
This was a very targeted bank run, and it caused some panic that spread to other banks that were found to have a large amount of uninsured deposits because as it turns out, these losses are widespread across US Banks.
A paper was just published by the NBER analyzing the US banking sector, and the results showed that the market value of bank assets is actually $2 trillion lower than book value. Banks are holding a large amount, $2 trillion, of unrealized losses. This is not a problem, unless customers pull their deposits, then you have to sell these assets at a loss. If customers don’t pull their deposits, then the bank can hold these assets and since they are mostly Treasury bonds and mortgages, they will recoup all losses over time.
To prevent a widespread panic, the Federal Reserve and Treasury Department opened the Discount Window and the Bank Term Funding Program or BTFP. Both of these programs operate in a similar way.
Let’s take a simple example that explains the situation. A customer puts money into the bank, and the bank pays the customer just 1% interest on the deposit. The bank then bought a Treasury bond yielding 2%. As the Federal Reserve raised interest rates, that Treasury bond declined in value, let’s say by 20%.
Now, the customer wants to pull their money out and the bank has to sell the Treasury bond. They won’t be able to sell the bond for enough money to repay the customer in full.
This situation would have caused insolvencies across many institutions if bank runs spread.
The Discount Window and BTFP allow banks to get a loan on this underwater Treasury bond, for the full amount of the bond. This allows the bank to pay customer deposits without anyone suffering a loss.
There is a catch, however that not many people are talking about.
The bank was previously funding itself with a customer deposit, paying about 1% interest. The loan from the Federal Reserve is not free, it cost about 5%.
So a bank went from paying 1% in interest to paying 5% in interest if they have to use these facilities. So a bank would only do this if they are in trouble, and if they do, it will very severely impact their earnings, as their interest costs would explode. So this program keeps a bank from going bankrupt immediately, but essentially makes it what’s called a “zombie bank,” or a bank that just exists but is so weak it can’t really function.
So the Federal Reserve has, for the time being, prevented a bank run from spreading, but there is a much more systemic problem that is starting to unfold.
The losses on the Treasury bond portfolio at US banks is a side show to the larger problem that threatens all smaller banks in the United States. This is going to be why more smaller banks fail in the coming months.
There is a massive difference between large banks and small banks in the United States. Large banks are generally deemed too big to fail and are thus implicitly backstopped by the government while smaller banks are not given that same designation.
Large US banks are also much more heavily regulated after the 2008 crisis.
Large Banks vs. Small Banks
At large US banks, cash and securities make up almost 40% of assets, while small banks have just 29% cash and securities.
So the Discount Window and BTFP facility don’t help small banks as much as large banks. Large banks have tons of securities to bring to the Fed facility, but small banks are very light on cash and securities.
At small banks, loans make up 65% of assets, while loans only make up 50% of assets at large banks.
So if a large bank faces deposit outflows, they can bring their securities to the Fed and get a loan. It’s an expensive loan, but they will have liquidity.
If a small bank faces a deposit outflow, they don’t have a lot of securities, so they may be forced to have to sell part of the loan portfolio, which then brings into question the real value of those loans, something most people turn a blind eye to.
Banks are notorious for paying basically nothing for deposits in terms of interest. Some large banks are still paying close to 0% while smaller banks that have to compete for money are trying to pay 1% or 2% interest. The problem is that Treasury bills are paying around 4.5% now.
So even without a targeted bank run, there will be a slow or potentially fast, leak of deposits that leave banks in search of very safe and much higher yielding Treasury bills.
You can see how deposits have been falling at both large and small US banks.
Small banks, as we have learned, hold mostly loans, not safe Treasury assets that are now easy to get a loan against.
Of that loan portfolio for small banks, 65% is real estate.
And that real estate portfolio is tilted very heavily towards commercial.
At small US banks, almost 70% of the real estate portfolio is commercial real estate.
At small banks, 41% of the real estate portfolio is non-residential property which could mean office buildings, and other heavily troubled sectors like retail stores.
We have further evidence that supports a large percentage of these loans for smaller US banks is, in fact, office buildings.
By contrast, real estate exposure is only 37% of total assets for large banks.
Of the real estate at large banks, it is two thirds residential. Large banks have mostly high quality residential real estate as all the risky commercial real estate was absorbed by smaller banks with less regulations.
Large banks don’t have nearly the same non-residential commercial property exposure as the small banks.
So what does this all mean?
It means that deposits are going to continue leaving both large banks and small banks because the rate that customers can earn on Treasury bills is much higher than what banks are able to pay in interest.
This won’t expose too many problems for large banks because they have a lot of cash, treasury bonds and mortgage bonds that they can use as collateral for loans at the Fed. It is costly, and it will reduce earnings, but not life threatening.
However, as deposits leave smaller banks, which they are for both reasons specific to certain banks and structurally because of higher interest rates on T-bills, this will expose massive problems.
Small banks don’t carry a lot of cash and securities and are very heavy on real estate loans, commercial real estate loans to be specific.
After the pandemic, office buildings never recovered as work from home became the new standard. The value of an office building can easily be down 30, 40 or even 50% from pre-COVID levels.
What this outflow of deposits from smaller banks will cause is price discovery on some of these potentially toxic commercial real estate assets that are sitting on small US bank balance sheets.
The Federal Reserve can easily deal with problems in Treasury and mortgage bonds, but it would be way outside the Fed’s mandate to deal in commercial real estate that is permanently impaired.
Before 2008, large banks did all the lending in the US economy. This chart shows the loan to deposit ratio of large and small banks.
After the 2008 crisis and regulations hit the large banks, small banks took over and now the loan to deposit ratio is much higher at small banks compared to large banks.
Small banks took on all the risky lending, including office buildings and retail stores specifically.
These assets have been permanently impaired, but the banking sector has not realized the losses yet.
Three years later, with almost no hope for these assets to recover, deposit outflows could force price discovery on these highly illiquid and impaired assets and that is the real problem facing the US banking sector. A wave of hundreds of billions if not trillions in potential losses on very impaired assets.
Small banks are the engine of credit growth to private economy. These recent events but more importantly, the structural gap between deposit rates and Treasury bill rates will cause a sustained outflow of deposits, particularly at smaller banks that have questionable loan portfolios and do not have the safety backstop of being too big to fail.
As lending growth stops at these smaller banks, businesses that are reliant on credit growth, particularly the real estate industry, with face a squeeze of available capital which could reinforce the downward pressure on already troubled commercial property assets.
It’s not a guarantee the situation evolves to this magnitude, but the risk is there, and the problem is that the numbers on the commercial real estate alone would leave the entire banking system with little to no equity and after a tax payer bailout in 2008 and constant assurances that the banking system is well capitalized, another tax payer bailout would not be well supported.