Banking on the Federal Reserve

Federal Reserve

Bank failures are rare. When most of us think about banks failing, we think about the Great Depression. For those of us above a certain age, we might also think about the bank failures of 2008 and the Great Recession. In any case, banks don’t fail every day, but last week we had two major bank failures within a couple of days.

These weren’t just bank failures either. Last week’s failures now rank as the number two and three largest bank failures in US history. The collapse of the Silicon Valley Bank and Signature Bank rank behind only the 2008 implosion of Washington Mutual.

Both recent bank failures seemed to come out of the blue. The Wall Street Journal details how the run on the Silicon Valley Bank (SVB) unexpectedly developed within hours. The immediate catalyst was a March 8 regulatory filing that announced a sale of assets. The filing triggered alarms with investors and depositors and soon the bank’s stock was in freefall. Depositors started moving their money, to the tune of $42 billion in attempted withdrawals not long after.

The root cause of the problem was the shifting economy. SVB was flush with cash from the pandemic era when savings rates were high and venture capital (VC) firms were pouring money into tech startups. The bank’s deposits leaned heavily toward large accounts that exceeded the FDIC limit for deposit insurance. The Journal notes that the majority of the bank’s funds, about $157 billion, were held in only 37,000 accounts.

All banks are required to maintain reserves that equal a certain share of their deposits as well as investing the deposits in assets. At SVB, with money coming in faster than it could be spent, a lot of this money went into very safe investments such as Treasury certificates and 30-year mortgages. The problem with these long-term investments was that they paid very low interest rates.

The low-interest investments weren’t a big problem until inflation started rising and the Fed raised rates in response. Add to that the fact that tech companies hit a rough patch as the pandemic ended and people returned to in-person businesses. Venture capital firms backing the tech startups became more tight with their money. Deposits fell as the tech companies burned through cash and their VC backers were slow to provide more. At the same time, the long-term investments that SVB had made lost value as interest rates rose, putting the bank into a cash crunch.

To provide cash, last Wednesday SVB sold off some of its investments at a loss as well as some of its own stock. This was the sale that was announced in the regulatory filing. When the news broke, the stock collapsed and the VC firms instructed their partner companies to move their money… if they still could. With bank shares in freefall, state and federal regulators stepped in to close the bank on Friday.

The rub is that the depositors who lost their uninsured deposits in SVB comprised a large number of companies that used the money to make payroll. If these companies couldn’t get to their funds, they couldn’t pay their workers, and the crisis might spread to other banks.

This was why the Biden Administration enacted emergency measures to protect the uninsured deposits of the bank’s commercial customers. On Sunday, the federal government announced that it would guarantee full access to these deposits in an attempt to stem further panic.

Nevertheless, it was too late to save Signature Bank in New York. On Friday, the bank’s customers attempted to withdraw $10 billion in deposits, prompting federal regulators to take control of the company on Sunday.

“We had no indication of problems until we got a deposit run late Friday, which was purely contagion from SVB,” former congressman Barney Frank, a current board member at Signature, told CNBC.

But Signature’s problems may go a bit deeper. Signature Bank was one of the main financial institutions for the crypto industry. As post-SVB fears spurred depositors to move their money from Signature, the bank was left with the riskier crypto business, but there is debate over whether the company was actually insolvent.

“I think part of what happened was that regulators wanted to send a very strong anti-crypto message,” Frank said. “We became the poster boy because there was no insolvency based on the fundamentals.”

There was also a third bank failure last week, but this one was not unexpected. Silvergate Capital, a troubled institution that also dealt heavily in cryptocurrency, closed its doors last Wednesday, the same day that SVB started to fail. Silvergate was a major partner of failed crypto-trading firm FTX. Signature and Silvergate were the two main banks servicing the crypto industry. The news of Silvergate’s failure may have spurred the run on SVB.

It isn’t clear whether more banks will fail, but a fourth institution is in trouble. First Republic Bank’s stock crashed on Monday morning, losing more than half its value before trading was halted. First Republic announced that it had more than $70 billion in liquidity guaranteed by the FDIC and JP Morgan Chase. Other bank stocks were volatile but mostly bounced back in later trading.

It isn’t clear whether the crisis is over, but the swift and strong reaction from the Federal Reserve seems to be tamping down most fears. The question is whether other banks have fallen into the same low-interest high-risk trap that bedeviled SVB and the crypto bankers.

As the Fed continues to raise rates to combat inflation, there is now a new concern about weakening banks. Further interest rate hikes could imperil the hoped-for “soft landing” for the economy, but failing to continue to raise rates could let inflation continue unchecked. Neither option is a good one, and the Fed is going to have to attempt to thread the needle.