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Deeper Fragility in the Banking Sector: Why Recent Turbulence Isn’t Just a Passing Phase

The recent collapse of many major US banks is simply symptomatic of an underlying issue in the banking sector, explains Senior Market Analyst at Trade Nation David Morrison

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  • Written by  David Morrison, Senior Market Analyst at Trade Nation
 
 
Deeper Fragility in the Banking Sector: Why Recent Turbulence Isn’t Just a Passing Phase

The first half of 2023 saw the most significant bank failures since the 2008 financial crisis. Silvergate and Signature failed, as did First Republic, who after seeing a flood of customer withdrawals, was taken over by JP Morgan in early May. Among them, most significantly, was the collapse of Silicon Valley Bank (SVB).

With about $209 billion in assets, and the U.S.’s 16th biggest lender as of the end of 2022, SVB lent more heavily to the tech sector than other banks who were more hesitant due to greater associated risk. However, one would be remiss to think there was a singular cause of such rampant collapse. There’s a deeper fragility in the banking sector that’s been overlooked.

Inconsistent regulatory response

As the first alarm bells started ringing around SVB, the U.S. government professed to be firm in its denial of a bail out. U.S. Treasury Secretary Janet Yellen, the Fed, and the FDIC faced pressure from lawmakers and industry groups to support the bank in a manner that would instil confidence among depositors and in the broader system.

However, panic had certainly set in. Hot on the heels of SVB, just days after the lender’s collapse, New York’s Signature Bank failed, First Republic Bank was taken over by JP Morgan, and many other regional banks and lenders saw their stock prices plummet. Seeing the chaos that ensued, the Treasury saw no option but to reverse their decision. Following pressure from the Fed and FDIC, a “systemic risk exception” was made for SVB, resolving the issue in a manner that would prevent all depositors from losing funds, both insured and uninsured.

The Fed later announced it would establish a new lending facility, the Bank Term Funding Program (BFTP), as an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress and protecting banks from unrealised losses in those portfolios. Importantly, the BFTP offers loans to federally insured depository institutions that provide US Treasuries and mortgage-backed securities as collateral and will value the assets at par. Even though this ruling can protect depositors in the short term, it also encourages banks to take more risks in the future.

Though the regulatory response to the SVB collapse has created optimism in the industry (bank stocks have steadily crept back upwards, as decisive action and bailouts have drastically reduced the likelihood of more major banks failing) there’s still considerable downside. It’s worth noting that the SPDR S&P Regional Banking ETF, while off its recent lows, has lost around a third of its value since the banking crisis hit back in March. In addition, if inflation is not tamed and interest rates continue to rise it’s possible that we may see more bank collapses.

The Fed’s perfect storm

A significant contribution to the collapse of these banks was the United States Federal Reserve Board’s recent actions. Over the past year, the Fed has been hiking interest rates quickly and aggressively in an effort to tame the country’s high inflation. From March 2022 to March 2023, interest rates rose from a band of 0.25%-0.5% to 4.5-4.75%. With an interest rate strategy that aggressive, there was bound to be a breaking point fast approaching. But it gets worse. Since then, the Fed has raised rates by an additional 50 basis points, taking them to an upper limit of 5.25%. Although the US central bank has just announced a pause in its rate hiking programme, this is likely to be a temporary measure. FOMC members are forecasting two more 25 basis-point rate hikes this year. If so, this would take the terminal rate up to 5.75%, the highest level since January 2001.

Considering the lead-up to this year’s banking crisis: as the Fed hiked rates, short-term interest rates rose above long-term rates. During the pandemic, tech startups with spare cash from funding rounds had placed their deposits with tech-friendly banks like SVB. Because these startups had bloated funding rounds under their belts, there was little demand for loans — so SVB invested most of the money in long term, “risk-free” bonds such as mortgage-backed securities and US Treasuries. As the Fed continued hiking rates, short-term interest rates rose above long-term rates, causing quite an issue for these lenders.

Turbulent times mean high withdrawals

Due to the high-interest rate environment the Fed has created, tech firms — who were increasingly struggling through funding rounds — began to withdraw and spend their deposits placed with SVB. At the same time, these higher rates led to the prices for the bonds that SVB invested in falling — squeezing SVB’s profit margins and unsettling its balance sheet.

To honour these increasingly prevalent withdrawals, SVB began selling some of its longer-dated bonds at a loss. Despite calls from SVB CEO Greg Becker for depositors to keep their funds with the bank, firms rushed to get their money out of the now publicly spiralling bank. This action forced further bond sales from SVB, quickly ushering in the last of the lender’s days.

On March 8th, 2023, SVB publicly announced that they were looking to raise $2.5 billion to shore up their balance sheet and recoup the $1.8 billion loss on the sale of securities. Just two days later, the California Department of Financial Protection and Innovation (DFPI) shut SVB down, appointing the Federal Deposit Insurance Corporation (FDIC) as its receiver. SVB was officially dead.

While recent bank sector failures are certainly a case study in what can happen from a particularly turbulent market, it simply exemplifies the banking sector’s deeper, ongoing weak points.

An inability to weather turbulence consistently and reliably, and an inability to learn from its mistakes and adequately manage risk makes for a dangerous combination — it wouldn’t be surprising if we suffer from another banking crisis in the future.


Author: David Morrison, Senior Market Analyst at Trade Nation

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