What type History unfolds in the banking system? At first glance it seems to be a tragic drama. In the past two weeks, four banks have met their demise: two crypto lenders, the dominant Silicon Valley bank, and most recently, a global systemically important bank. There have been 11-hour interventions to protect customers, the creation of emergency credit facilities, and a marriage between two giant rival firms.
But look again and maybe it’s a sci-fi story. Thomas Philippon, Professor of Finance at New York University (no), experiences the dizziness of time travel. “It really feels like we’re back in the 1980s,” he said at a recent talk. During that decade, high inflation led to extreme monetary tightening, which was enthusiastically received by Federal Reserve Chairman Paul Volcker. This undermined the health of the “savings banks” (S&ls), also known as “savings banks”, which mostly granted long-term fixed-rate mortgages. They faced a cap on the rate they could pay on deposits, leading to flight. And they held fixed income assets. As interest rates rose, these mortgages fell significantly in value – essentially wiping out the net worth of the thrift industry.
The dynamic will be familiar to anyone familiar with Silicon Valley Bank (svb), where an interest rate shock drastically reduced the value of its fixed income assets, leading to deposit flight and the collapse of the institution. The question now is whether what happened in the last two weeks was a brutal crisis or the beginning of a protracted process like in the 1980s. The answer depends on how much svb‘s problems are to be found elsewhere.
Start with the value of financial institution assets. Banks regularly release data on the losses they face on fixed income assets such as bond portfolios. If those assets had to be liquidated tomorrow, the industry would lose nearly a third of its capital base. It is worrying that every tenth institution is less capitalized than svb.
That’s a big “if” though. Such paper losses remain hypothetical as long as there are depositors. A recent paper by Itamar Drechsler of the University of Pennsylvania and co-authors suggests that bank deposits, which tend to be stable and interest-rate sensitive, are a natural hedge for the kind of long-term, fixed-rate lending that banks favor. The paper argues that “banks fine-tune the interest rate sensitivities of their interest income and expenses,” resulting in remarkably stable net interest margins. This explains why bank stock prices don’t fall every time interest rates rise, but fall just as much as the broader market.
The clearest evidence of the escape comes from two California-based banks. First Republic has reportedly lost $70 billion in deposits since then — roughly 40% of their total by the end of 2022 svb failed. Many of the lender’s customers are wealthy individuals who appear to be the quickest to withdraw deposits. On March 17, the First Republic arranged for 11 major banks to park $30 billion worth of deposits with it. It is now reported to be seeking additional support from financial institutions and possibly the government as well. On March 21, PacWest, another California lender, reported that it had lost a fifth of its deposits since early 2023.
Banks suffering from deposit flight, like First Republic and PacWest, can turn to other financial institutions for liquidity — or they can turn to the Fed’s newly expanded lending facilities. Official data shows that in the week ended March 15, American banks borrowed $300 billion from various Fed programs. There is some evidence that most borrowings that are not made by already-failing banks—viz svb and Signature – was conducted by West Coast banks including First Republic and PacWest. In fact, about $233 billion of the total was lent by the San Francisco Fed, covering banks west of Colorado. On March 21, PacWest announced that it had borrowed a total of $16 billion from various Fed facilities to shore up its liquidity. All Fed banks supporting other regions of the country have borrowed at most around $2 billion, suggesting banks in other states are yet to contend with a debilitating deposit flight.
Political decision-makers will now have to wait and see whether other banks come forward. It will be an uncomfortable pause. Regional and community banks play an important role in America’s economy, providing about half of the nation’s commercial lending. Smaller banks dominate, especially in commercial real estate. They hold nearly 80% of commercial mortgages issued by banks. The temptation, about which US officials are vague, is to ensure smaller banks don’t lose their deposits by guaranteeing them all.
Aaaaarrggggghhhhh
This could result in a dark scenario: a zombie horror flick. At least that’s the argument made by Viral Acharya, also by no. Banks with volatile deposits and lost assets face real losses. The worst possible outcome, argues Mr Acharya, is that “you leave the banks undercapitalized but you say that all depositors of weak banks are safe”.
This type of intervention, he says, is historically common, and “whenever this has been done — it’s happened in Japan, happened in Europe, happens routinely in China and India — there are zombie banks.” These have no capital, are backed by governments, and “tend to issue a ton of bad loans.” He points to the Bank of Cyprus, which was undercapitalized in 2012: “They bet the whole house on Greek debt even when Greece actually exploded. Why did they do this? Well, they had stable deposits, nobody liquidated them, they ran out of equity – and shortly after that you had a spectacular bank collapse.”
America’s thrift crisis of the 1980s was ultimately so costly because the first reaction—when thrift suffered losses of some $25 billion—was leniency. Many insolvent thrifts were allowed to remain open to try to grow out of their losses. But their problems only got worse. They, too, became known as “zombies”. Just like the Bank of Cyprus, these zombies went broke by investing in increasingly risky projects in the hope that they would reap higher returns. When the returns came in, the zombies were insolvent. The eventual bailout cost taxpayers $125 billion, five times what it would have cost had regulators bitten the bullet sooner. It would be a real tragedy to play that kind of zombie flick again. ■
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