In March, the US suffered a series of bank collapses, with two relatively large banks, Silicon Valley Bank (SVB) and Signature Bank, collapsing in the space of a week. This prompted fears of a 2008-style financial crisis.
However, a month or so later, it seemed like a crisis had been averted when the Federal Reserve extended its deposit guarantee. Despite these measures, America’s banking crisis has restarted, with the collapse of First Republic Bank and rapidly falling shares in smaller regional US banks. In this article, we’ll examine what caused America’s slow-moving banking crisis in the first place and why First Republic collapsed.
The Origins of the Banking Crisis
The banking crisis was actually caused by the recent rise in interest rates. Central banks across the world, including the US, have been raising interest rates in an attempt to bring down inflation. In theory, higher rates should reduce borrowing and therefore consumer demand, ultimately bringing down prices.
In a simple world where banks just lend money to creditworthy customers, higher interest rates should be good news for banks because it means they make more interest from lending money. However, banking is no longer as simple as it once was, which means that higher rates can have unforeseen impacts on banks.
With Signature Bank, for example, higher interest rates reduced speculative pressure on crypto assets, bringing down the price of crypto assets that the bank was holding. With SVB, higher interest rates reduced the real value of its treasury holdings, which meant that when its depositors asked for their money back, SVB didn’t have enough cash to actually pay them.
When SVB and Signature went bankrupt, many people were worried that this could spread into a proper 2008-style banking crisis. The concern was that depositors would see what happened to these banks and rush to take their money out of the banking system, triggering a system-wide bank run with everyone racing to get their money out before the banks run out of cash.
This would be a catastrophe, as banks would have to stop lending to make sure they have as much cash on hand as possible, which would almost definitely trigger a recession. And even then, they probably wouldn’t have enough cash to actually pay all their depositors.
To avoid this, the Federal Reserve announced that they would be extending their deposit guarantee to cover deposits over $250,000. The Fed aimed to stem the bank runs by assuring people that they didn’t need to worry about taking their money out because the Fed would pay them back, even if their bank went under.
Why More Banks are Now Collapsing
Despite the Federal Reserve’s guarantees, the banking crisis has continued to affect smaller banks, which aren’t covered by the deposit guarantee. As a result, customers have been shifting their money to larger, better-insured banks, putting immense pressure on smaller banks like First Republic.
First Republic lost $100 billion, representing over 50% of all their deposits. The bank’s collapse was temporarily averted when a consortium of private banks, led by JP Morgan, agreed to bail them out with a $30 billion cash injection. However, this wasn’t enough, and First Republic eventually collapsed.
Since then, many other smaller banks, primarily regional ones, have shown signs of distress. Regional bank stocks have been falling fast as depositors race to withdraw their money. Several factors are contributing to the collapse of these mid-sized regional banks:
- The Fed is slowly withdrawing support for certain parts of the credit market, which mostly affects banks.
- Further interest rate hikes appear more likely than they did a few weeks ago.
- There’s the risk of debt ceiling-induced US default.
- Regional banks are particularly exposed to US commercial real estate, like office spaces, which is looking shaky at the moment.
Ultimately, this looks like an old-fashioned bank run. Depositors are worried and racing to get their money out, causing a self-perpetuating cycle. The speed of bank runs is accelerated due to online banking, making it easier for people to withdraw their money. Additionally, short sellers bet against the bank, pushing down the value of its shares and making default more likely.
What Happens Next?
It’s uncertain what will happen next, but if things continue to go downhill, the Fed has two options, neither of which is ideal:
- Extend its deposit guarantee further to include all US banks: While this might stem the crisis, it’s a de facto nationalization of the banking sector and creates enormous moral hazard. If banks know that the Fed will cover them if they go bust, they have no incentive to be careful with their lending, which means they’ll start taking excessive risks and lending to bad businesses, harming the economy.
- Impose stricter reserve requirements: Banks would have to hold more cash in reserve to better protect against bank runs. Although this might be a sensible reaction to the fact that bank funds now take hours instead of weeks to withdraw, it’s more of a long-term solution and might not solve the immediate crisis. This would also lead to an economic slowdown, as more reserves mean less lending from banks, resulting in less money and less growth.
In conclusion, the situation with US banks collapsing is not looking great, and there are no easy solutions for the Fed to implement. The unfolding crisis highlights the need for both short-term measures to address the immediate problem and long-term changes to create a more stable banking system.