Why Are Banks Failing Again? Part 1

Three regional banks have collapsed in the US. The spectacular failures of Silicon Valley Bank, Signature Bank and Silvergate abruptly ended a 10-year period when the U.S. did not have a banking crisis. That was a sharp departure from the typical banking cycle, which has usually blown up every three to four years, offering a sacrificial victim up on the altar of capitalism.

This situation is not a repeat of the 2008 financial crisis. The banking industry is sound overall, and the largest U.S. institutions are in good shape. There’s no need for you to put your money under a mattress (but make sure you stay under the $250,000 limit for deposit insurance).

Silicon Valley Bank collapsed mostly because its management rolled the dice and did not hedge its bond portfolio. When the bank took big losses on the bonds, scaring investors, that triggered a bank run.  But the bank’s failure is also a wake-up call for the industry; it exposed important cracks in the system. The Federal Reserve Bank must tighten its regulation of so-called “midsize” regional banks with over $100 billion of assets. SVB and other institutions took advantage of loosened rules, and some bank supervisors dropped the ball.

Now, bank runs can happen at warp speed. Social media spreads bad news and rumors in seconds. Depositors can move their funds almost immediately, through digital channels. The banking system may have become more fragile on a long-term basis.

Spike in Interest Rates

Those halcyon 10 years without significant bank failures were probably an aberration. That remarkable period of stability reflected three main factors:

• The Dodd-Frank banking reforms that Congress passed after the 2008-09 financial meltdown

• The Federal Reserve’s much tighter regulation of the 10 largest banks post-crisis

• Extraordinarily stable and low interest rates

After the 2008 turmoil, big U.S. banks faced much higher capital requirements and annual stress tests, as well as constant, in-depth monitoring by Fed examiners. Furthermore, interest rates remained remarkably low and stable, partly because of the Fed’s policies.

But as inflation flared, the Fed began to raise interest rates in March 2022. The Fed had to play catch-up because it had underestimated the extent of inflation. As a result, Fed Chair Jerome Powell and the other Fed governors have lifted rates at a very fast clip: from zero to almost 5% in 12 months. This steep climb in rates caught some banks, including SVB, way off guard.

Here is an ironclad rule about banks: when interest rates shift abruptly, either up or down, some lenders get into trouble. This always happens.

Misguided Regulatory Rollback

The regulatory climate changed, too. Regional banks lobbied hard to weaken the banking regulations applied to them under Dodd-Frank. Bank CEOs argued that their firms were less risky than the mega-banks and had fewer resources to bear the higher regulatory costs imposed under the new framework.

Officials in the Trump Administration, who were pursuing deregulation in many sectors, were sympathetic. In particular, Randall Quarles, whom President Trump appointed in 2017 as Vice Chair of Supervision, pushed to weaken capital requirements and other regulations on all banks and particularly regional ones.

In 2018, the regional banks got their wish, and Congress eased the regulatory regime for them. Congress raised the threshold for the Dodd-Frank requirements from $50 billion to $250 billion in assets, so the law no longer applied to most regional banks.

Virtually all Republican lawmakers voted to relax the requirements. Although some Democrats supported the revisions, most opposed them. One-third of Democratic Senators, and only 20% of Democratic Representatives, voted in favor of the changes.

Bank supervisors do not work in vacuum. They probably realized that the political atmosphere on bank supervision had changed, especially given Quarles’ views. Some of them may have interpreted the shifts as a mandate to ease up on regional banks.

Silicon Valley Bank: The Bad and The Ugly

Greg Becker, Silicon Valley’s CEO, was deeply involved in the lobbying effort to soften the oversight for regional banks like his. Becker sat on the board of the San Francisco Fed, which supervised SVB. It’s not usual for bank presidents to serve on a Fed Board, and Becker’s presence may or may not have influenced SVB’s examiners.

In any event, SVB’s regulators missed some flashing red lights:

• SVB quadrupled its assets in just four years, growing from $50 billion to about $200 billion in assets.

• SVB amassed a bond portfolio of $100 billion…but did not hedge its interest rate risk.

• The bank had a very concentrated business mix/clientele: Silicon Valley start-ups.

• Over 90% of its deposits were not covered by the Federal Deposit Insurance Corporation

SVB had developed a better mousetrap, in some ways. The bank provided venture capital investors and start-up founders with a high level of service and financing options that they simply could not obtain from a Wells Fargo or a JPMorgan. For instance, SVB would grant mortgages to start-up founders, who often do not earn much money until they can take their firm public or sell it.

SVB became the banking hub for the tech industry, scooping up deposits from investors and founders alike.

SVB Customers Yanking Their Deposits/Getty Images

The Curse of Rapid Growth

But here’s another fundamental rule for banks: rapid growth leads to disaster. When a bank grows much faster than its peers, management is probably cutting corners and taking too much risk.

SVB threw caution to the winds. As its deposits soared, the bank could not generate enough loans, so it invested half of its funds in Treasuries and mortgage-backed securities. That strategy seemed safe, but the bank violated a cardinal rule of risk management. SVB did not buy interest-rate hedges or take other steps to protect the value of its huge portfolio.

That move was especially dangerous because SVB almost doubled its assets—by about $100 billion--in 2021. So SVB bought enormous amounts of bonds in the 12 months before the Fed started to jack up interest rates.

Interest Rate Armageddon

SVB took huge losses on its holdings of short-term and long-term bonds during 2022 and early 2023. Rates on 2-year and 4-year Treasuries doubled from 2% to 4%-plus, slashing the bonds’ market values. Longer-dated Treasuries, a large component of SVB’s portfolio, lost 30% of their market value, according to Bloomberg.

However, under the more lenient accounting rules for regional banks, SVB did not have to include those mark to market unrealized losses in its earnings. Mega-banks like Citibank and Bank of America do have to reflect such losses in their results, and that affects their approach to managing their portfolios. The banks also talk frequently with their examiners about their portfolio hedging.

SVB’s senior management was quite aware of the risks. CEO Becker ignored pleas from employees to hedge the portfolio. The bank also disregarded increasingly strident demands from Fed supervisors during 2022 to reduce its interest-rate risk. It is highly unusual for a bank to defy such warnings from regultators.

Why did Becker push the envelope so far? The CEO wanted to maximize the bank’s profits on its portfolio, which would help to raise the price of SVB stock...and the value of his stock options. After all, it costs money to hedge a bond portfolio, especially one that has shot up to $100 billion.

The Music Stops…

SVB could have continued along in this fashion, if it did not have to sell down its bond portfolio. However, investors began to worry about the embedded losses in the bank’s portfolio, and deposits started to leak out of the bank.

In February and early March, SVB had to sell about 10% of its bond portfolio to redeem deposits, which triggered a loss of $2 billion. That was a big chunk of the bank’s $12 billion of equity, so management decided to raise more capital.

On Wednesday, March 8, 2023, as part of its capital raise, SVB provided an update to its investors on its unrealized losses. Investors were shocked. They quickly realized that if the bank had to sell most of its portfolio at current market prices, it would have almost no equity. Time to head for the hills.

Social Media: The Great Accelerator

SVB’s highly concentrated client base also contributed to its swift demise. The start-up community is tight, very inter-connected. Although many tech clients had large deposits with SVB, the accounts mostly represented the capital raised to fund their operations, not personal investments.

Many founders pay themselves modest salaries as they build their companies. They are not wealthy. These entrepreneurs face massive business risk, so they cannot take any financial risk. Furthermore, they did not have a safety net at SVB; FDIC insurance covered less than 10% of the bank’s deposits.

On Thursday, March 9, as word spread about SVB’s investment losses—rapidly, through social media—tech investors and founders yanked their deposits. The bank run accelerated when two venture capital firms advised their start-ups to move their funds out of SVB. Tech-savvy founders could initiate the deposit transfers on their own computers, without going through SVB. They could move their funds in a matter of minutes.

In one day, SVB lost almost $50 billion or 25% of its deposits. The FDIC seized the bank the following day, March 10.

We will propose possible measures the government could take to reduce the chances of another bank run in Part 2 of this article.

The Wall Street Democrat