Only ten days ago one would have thought that the banks were already fixed after the nightmare of the financial crisis of 2007-2009. It is now clear that they still have the ability to deliver powerful shocks. On March 9, a fierce panic at Silicon Valley Bank (SVB) saw $42 billion worth of deposits disappear in a single day. SVB is just one of three US lenders to fail within a week. Regulators worked frantically over the past weekend to engineer a bailout. All in all, customers are once again wondering if their money is safe.
Investors have been spooked. Some $229 billion in market value has disappeared from US banks so far this month, down 17%. Treasury yields have plummeted and markets now believe the Federal Reserve will start cutting interest rates in the summer. The share prices of European and Japanese banks have also plummeted. Credit Suisse, which is facing other difficulties, saw its shares fall 24% on March 15 and on March 16 requested liquidity from the Swiss central bank. Fourteen years after the financial crisis, questions are swirling again about the fragility of banks and whether the situation has caught regulators by surprise.
The swift collapse of SVB has shed light on an underappreciated risk within the system. When interest rates were low and asset prices high, the Californian bank hoarded long-term bonds. Later, when the Federal Reserve raised rates at its fastest pace in four decades, bond prices plummeted and the bank found itself with huge losses. US capital rules do not require most banks to consider the price decline of the bonds they intend to hold to maturity. Only very large banks should mark to market all bonds that are available for trading. Now, as SVB discovered, if a bank falters and has to sell bonds, the unrecognized losses become real.
Across the US banking system as a whole, those unrecognized losses are huge: $620 billion by the end of 2022, which is equivalent to about a third of the combined capital buffers of all banks in the country. Fortunately, other banks are much further from the brink than SVB was. Despite everything, the rise in interest rates has left the system in a situation of vulnerability.
The 2007-2009 financial crisis was the result of reckless lending and a real estate bankruptcy. For this reason, post-crisis regulations sought to limit credit risk and ensure that banks held assets that had reliable buyers. They encouraged banks to buy government debt: after all, no one is more creditworthy than Uncle Sam, and nothing is easier to sell in a crisis than Treasuries.
Many years of inflation and low interest rates made few wonder how banks would suffer if the world changed and long-term bonds lost value. Such vulnerability only got worse during the pandemic, as deposits flooded banks and Federal Reserve stimulus pumped cash into the system. Many banks used the deposits to buy long-term bonds and government-guaranteed mortgage-backed securities.
You might think that unrealized losses are unimportant. One of the problems is that the bank has bought the bond with someone else's money, usually a deposit. To hold a bond to maturity, you need to offset it with deposits, and as rates rise, competition for deposits increases. At bigger banks, like JPMorgan Chase or Bank of America, customers tend to stick around, so higher rates tend to boost their profits thanks to variable-rate loans. By contrast, the roughly 4,700 small and medium-sized banks, with total assets of $10.5 trillion, have to pay depositors more to prevent them from withdrawing their money. That reduces their margins, which explains the fall in the stock prices of some banks.
The other problem affects banks of all sizes. In a crisis, once-loyal depositors may flee, forcing the bank to cover deposit outflows by selling assets. If that happens, losses crystallize. The bank's capital cushion may seem comfortable today, but most of its padding suddenly becomes accounting fiction.
That alarming prospect explains why the Federal Reserve acted so drastically this past weekend. Since March 12, it has been willing to grant loans guaranteed with bank bonds. While previously imposing a haircut on the value of the collateral, it will now offer loans up to the face value of the bonds. For some long-term bonds, that price can exceed market value by more than 50%. In the face of such largesse, it is almost impossible for unrealized losses on a bank's bonds to cause a collapse. And that means the bank's depositors have no reason to start a rout.
The Federal Reserve is right to lend against good collateral to stop leaks. However, such easy conditions come at a cost. By creating the expectation that the Federal Reserve will take on interest rate risks in a crisis, they encourage banks to behave recklessly. The emergency program is only supposed to last one year; but, even after it has expired, banks competing for deposits will seek high returns by taking excessive risks. Some depositors, knowing that the Federal Reserve has already intervened once, will not have much reason to discriminate between good and bad risks.
Therefore, regulators must take advantage of this year of time to make the system more secure. One step is to remove many of the strange exemptions that apply to midsize banks, some of them due to lobbying in 2018 and 2019 that succeeded in reversing post-crisis rules. The bailout of depositors at SVB shows that policy makers think these banks pose systemic risks. In that case, they must face the same accounting and liquidity rules as megabanks (as in Europe) and be required to submit plans to the Federal Reserve for their orderly resolution in the event of bankruptcy. In practice, this will force them to increase their margins of safety.
Everywhere, regulators must also create a regime that recognizes the risks of rising interest rates. During a crisis, a bank with unrealized losses will be at greater risk of failing than one without. However, that disparity is not reflected in the capital requirements. One idea is to run stress tests to see what would happen to a bank's safety cushion if its bond portfolios are valued at market prices and if rates continue to rise. Policy makers could then consider whether, based on the result, the system has enough capital.
The bankers will not like the idea of more capital buffers and more rules. However, the security benefits are enormous. From Silicon Valley to Switzerland, depositors and taxpayers are in for quite a shock. They should not be forced to live with a fear and a fragility that they already considered to have belonged to history for years.
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Translation: Juan Gabriel López Guix