The Banking Tremors

The collapse of two banking institutions, Silicon Valley Bank (SVB) and Signature Bank, and signs of instability among other institutions, has roiled financial markets and added to the overall uncertainty surrounding the economy.

The two collapses are basically attributable to the depositor base and high interest rate environment rather than to a portfolio of risky investments. In each instance, nontraditional depositors, some of whom were loan customers of the banks, maintained deposits far in excess of the $250,000 Federal Deposit Insurance Corporation insurance limit and then got spooked by reports of financial instability of the banks. These customers suddenly demanded to withdraw their money.

Unfortunately, many of the banks’ assets were in longer term Treasury securities. These assets are stable and virtually risk free if held to maturity, but their market value declines as interest rates rise, so the holding bank can incur large losses if they are sold prior to maturity. Both closed banks were unable to find sufficient assets to pay demands for withdrawals and a run on the bank ensued, despite frantic last minute efforts to raise liquidity and capital. Both banks were closed by regulators, although, significantly, the FDIC decided to insure deposits in excess of $250,000.

The immediate question is whether the banking and regulatory system can fight off a wave of potential new crises. First Republic Bank, whose operations have been compared to those of SVB, received an infusion of deposits from JP Morgan Chase and other major institutions. Overseas, Credit Suisse, which has substantial operations in the United States, has been rescued in a purchase by UBS Group at a reduced price.

At this point we don’t really know if there are many other situations like SVB and Signature out there. It could be that quick actions by regulators, combined with the willingness of the FDIC to pay off uninsured depositors of the two failed banks, will act to lessen the chance of stampedes by depositors eager to get their money. On the other hand, it will be much harder to deal with these cases if there are dozens or hundreds around the country.

One significant fear associated with the current banking problems is that it heightens the risk of recession. Many economists believe that, even if the efforts to shore up the banking system succeed (not viewed as a given), there still will be repercussions on the economy. Banks will push back on lending and businesses will struggle to borrow money. Presumably, this will lead to less expansion and hiring, or even cash flow issues.

One immediate question is what the Federal Reserve Bank will do in the short term with interest rates in the wake of the banking problems.  The Fed has been on a campaign to ratchet up rates to tamp down the substantial rate of inflation, which is still around 6 percent.  On one hand, there is a desire to finish the job of lessening the price increases and to indicate resolve in doing so.  On the other hand, if the banking issues are already leading the country into recession, the Fed does not want to pile on. 

Even if we manage to stave off a recession, the recent banking problems raise a number of issues. First is the wisdom of excessive federal spending in the waning days of the pandemic, which likely produced the underlying inflation that led to the problems with bank assets.  Second is the adequacy of the bank regulatory structure, both as it relates to medium sized banks (which are regulated less than their larger counterparts) , but also to assets that are intended to be held by banks to maturity; these should probably be marked to market for accounting purposes. Third, the wisdom of allowing banks to hold large amounts of uninsured deposits with the unwritten expectation that the insurance limits will be waived.  Certainly, even if we do dodge most financial bullets, the recent tremors need to be taken seriously and appropriate measures taken.     

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