The Collapse of US Banks: A Road to Global Financial Crisis?

In response to the recent banking crisis, US President Joe Biden has pledged to take action against those responsible. However, the root cause of the issue may lie deeper within the American banking system, which is plagued by inflation, dubious balance sheets, and rising interest rates.

Martin Gruenberg, the head of the Federal Deposit Insurance Corp (FDIC), recently warned of a $620 billion risk in the US financial system. By Sunday, a third bank, Silvergate Capital Corp, had also failed, leading to a major showdown in the US banking industry.

What is happening?

The financial industry is under significant strain as customers withdraw their deposits, investors move towards safe investments, and regulators struggle to keep up after years of inaction. Unlike the financial crisis 15 years ago, which was triggered by the housing market collapse in the US, the current situation is caused by rapidly increasing interest rates. The two most significant bank failures since the Great Recession, collapsed, highlighting the instability of financial institutions. First Republic Bank also required aid from other banks to stay afloat. Credit Suisse, a European banking giant, has also faced concerns about its stability. 

However, the problems have been developing for months and are not sudden.

Rising Interest Rates

When interest rates increase rapidly over a short period of time, banks face interest rate risk. This is currently happening in the United States, where the Federal Reserve has been aggressively increasing rates since March 2022, in an attempt to control inflation. So far, the rates have been raised by 4.5 per cent, resulting in a commensurate rate jump.

According to a report by the Associated Press, in March 2023, the yield on one-year US government Treasury notes reached a 17-year high of 5.25%, up from less than 0.5% at the beginning of 2022. The yields on 30-year Treasurys have also risen almost 2 per cent. As the yield on a security increases, its price decreases, leading to a chain reaction. A rapid rise in rates over a short period of time can cause the market value of previously issued debt (such as corporate bonds or government treasury bills), particularly for longer-dated debt, to plummet.

SVB faced a challenge due to its possession of bonds that were acquired during a period of low-interest rates. In response to rising inflation, the Federal Reserve increased interest rates eight times in the past year. Consequently, newer bond versions became more attractive to investors compared to the bonds SVB held.

Classic Bank Run

The slowdown of the tech industry led to some of SVB’s clients withdrawing their funds. The bank sold $21 billion of bonds to generate the required cash to repay depositors, resulting in losses of almost $2 billion. These losses raised concerns among investors and some of the bank’s clients regarding the possibility of similar unprofitable assets on SVB's balance sheet, which could impede the bank's ability to repay its depositors.

The SVB faced a crisis when its customers began withdrawing deposits exceeding the bank's available cash reserves. To meet its obligations, the bank sold $21 billion of its security portfolio, incurring a loss of $1.8 billion. The resulting reduction in equity prompted the bank to seek to raise over $2 billion in new capital, according to an AP report.

The request to raise equity alarmed SVB's customers, who were already sceptical of the bank and quickly withdrew their funds. In today's digital age, a bank run can potentially bankrupt even a financially sound bank in a matter of days.

The US Financial Crisis

According to data released by the Federal Reserve on Friday, deposits at all U.S. commercial banks in the week ended March 22 decreased to their lowest level since August, albeit at a slower rate than the previous week. Deposits stabilized at small banks perceived to be more vulnerable to outflows after the collapse of Silicon Valley Bank. The $125.7 billion reduction in deposits was $50 billion less than the record outflows of $174.5 billion in the first week following the collapses of Silicon Valley Bank and Signature Bank. Nonetheless, total deposits remained almost $860 billion lower than their all-time high in April of last year, with roughly $300 billion of that decline occurring in the weeks after the failure of SVB and Signature. U.S. financial authorities have repeatedly stated that deposit flows have stabilized following the historic run on deposits at both banks. Deposits at the two banks fell by nearly $30 billion, the largest decline since June 2021. However, it is unclear if the drop was due to the collapse of the two banks. Other categories of bank lending, such as commercial and residential real estate, consumer credit cards, and car loans, have seen little change since the banking turmoil began earlier this month.

The Dodd-Frank Act

The Dodd-Frank Act's Section 165 implemented regulations known as "enhanced prudential regulation" that applied to banking organizations with assets exceeding $50 billion, identifying them as "systemically important financial institutions" or "too big to fail." These regulations were stricter than those imposed on smaller banks, as lawmakers recognized that the larger institutions posed greater risks to the U.S. financial stability.

One of the requirements of these regulations was that banks deemed too big to fail had to periodically provide the Federal Reserve and the Federal Deposit Insurance Corp. with a comprehensive resolution plan, known as a Living Will, which outlined how the bank would be dissolved quickly and orderly in the event of failure or potential failure. Additionally, these banks were required to evaluate their risk under various market conditions, such as increases in interest rates and risk management strategies. The regulations also mandated higher capital requirements for designated banks.

However, when the failed banks were no longer obligated to comply with these regulations, they did not. It could be argued that if they had followed the provisions, it might have saved them from failure.

There is ongoing debate regarding whether the Dodd-Frank standards could have prevented the recent bank failures and addressed them more quickly. These standards were designed to prevent and mitigate the types of circumstances that triggered the failures, including contagion in the financial system, market panic, deposit runs, and liquidity crises.

For instance, adhering to Living Wills and stress testing could have detected issues earlier and compelled banks to address potential red flags indicating higher risk. These red flags may have included interest rate risk in the banks' securities portfolio investments, the consequences of selling those investments at a significant loss during a cash crisis, lack of interest rate risk hedging strategies, excessive uninsured deposits that could pose a risk if customers withdrew their money in large amounts, and the need to maintain higher-than-normal levels of capital to address risks.

The Global Bank Crisis: A Domino Effect

Direct support of over $400 billion has been provided thus far from banks in different countries. Silicon Valley Bank and Signature Bank's deposits have been guaranteed by the US Federal Reserve, with a commitment of $140 billion. Additionally, the Swiss National Bank provided Credit Suisse with an emergency loan of $54 billion, and UBS was offered loans amounting to 209 billion Swiss francs ($225 billion) and protection against potential losses, guaranteed by the Swiss government.

The Fed has also agreed to record levels of loans to other banks in recent days. Almost $153 billion was borrowed by banks from the Fed, surpassing the previous record of $112 billion set during the 2008 crisis. Furthermore, banks have drawn on nearly $12 billion of loans from the Fed's emergency lending program, which was established at the beginning of the week to prevent further bank collapses.

The Fed has loaned a total of $318 billion to the financial system, half of what was extended during the global financial crisis. However, it is still a significant amount, according to JPMorgan's Michael Feroli in a note to investors. He added that while one view is that banks require a lot of money, another view is that the system is working as intended.

The banking industry has contributed billions as well. JPMorgan Chase, Bank of America, and Citigroup, among others, are providing a $30 billion cash infusion to bolster confidence in First Republic Bank. Furthermore, HSBC has reportedly committed over $2 billion to SVB's UK business, which it purchased for £1 on Sunday.

The Road Ahead

At present, it is unlikely that the collapse of SVB and Signature will have a ripple effect on the broader banking industry. Swift regulatory action has helped to boost market confidence and prevent bank runs by providing extra liquidity in exchange for eligible assets. The Federal Reserve, the Federal Deposit Insurance Corporation, and the Treasury Department have committed to ensuring that all depositors in the two banks regain access to their funds, even those not covered by the government's deposit insurance scheme. Any losses incurred by the deposit insurance fund will be recovered through a special levy on other banks, not taxpayer funds.

While the financial sector may be affected by rising interest rates, the unique positions of SVB and Signature contributed to their collapse. SVB's high exposure to risky technology start-ups and its large bond portfolio made it vulnerable to the sharp rise in interest rates. Similarly, Signature's connections with the cryptocurrency sector, which has been uncertain since the failure of the FTX exchange in November, also played a part. In addition, most of the deposits at both banks exceeded the $250,000 limit for federal deposit insurance, making them more susceptible to withdrawal at the first sign of trouble. Despite this, higher interest rates will remain a financial risk in 2023-2024.

At its March meeting, Fed officials were considering a more significant 50-basis-point rate increase, but the collapse of the two banks and the subsequent drop in regional bank shares have eliminated this possibility. There is now a possibility that the Fed may not increase interest rates. However, the Fed may continue with its more moderate pace and raise interest rates by 25 basis points in response to strong economic data from January and February.

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Pic Courtsey-Baudouin Wisselmann at unsplash.com

(The views expressed are those of the author and do not represent views of CESCUBE.)