Is the banking business model broken?

How much the picture has changed! Just at the beginning of March you might have thought that the banking system is in good shape and the nightmare of the global financial crisis a thing of the distant past.  

About three weeks later the banking sector is in full crisis mode. 

Silicon Valley Bank, the largest bank by deposits in Silicon Valley, has been placed into receivership after massive losses on its holdings in US treasuries and a bank run caused the second-largest bank failure in US history.  

New York-based Signature Bank, a full-service commercial lender, had to be closed after nervous customers withdrew more than US$ 10 billion in deposits.  

Shares in First Republic Bank, a San Francisco headquartered provider of wealth management services, slid more than 60 percent on concerns of a bank run. The lender secured a US$ 30 billion support from eleven of its larger competitors.  

And in Europe, Credit Suisse will be bought by UBS in a historic, government-brokered deal aimed at containing a crisis of confidence. UBS is paying 3 billion Swiss francs (US$3.2 billion) for its rival in an all-share deal that includes extensive government guarantees and liquidity provisions. The price per share marked a 99% decline from Credit Suisse’s peak in 2007.  

The banking sector is back in crisis mode. The escalated funding strains are best illustrated by the US$ 164.8 billion borrowed by banks from two Federal Reserve backstops in the week ended March 15 – the traditional discount window and the Bank Term Funding Program, which was launched after the Silicon Valley Bank failure.  

The US$ 152.9 billion borrowing from the discount window is a record high and even surpassing the US$ 111 billion reached during the 2008 financial crisis!

Investors have taken fright. More than US$ 200 billion has been wiped off the market value of America’s banks this month, a fall of 17 percent. Treasury yields have tumbled, and markets now expect the Federal Reserve will begin cutting interest rates in the summer.  

The high-speed collapse of SVB has cast light on an underappreciated risk within the system. When interest rates were low and asset prices high the Californian bank loaded up on long-term bonds. Then the Fed raised rates at its sharpest pace in four decades, bond prices plunged, and the bank was left with huge losses.  

America’s capital rules do not require most banks to account for the falling price of bonds they plan to hold until they mature. Only very large banks must mark to market all their bonds that are available to trade. But, as SVB discovered, if a bank wobbles and must sell bonds, unrecognized losses become real. 

Across America’s banking system, these unrecognized losses are vast: US$ 620 billion at the end of 2022, equivalent to about a third of the combined capital cushions of America’s banks. Fortunately, other banks are much further away from the brink than SVB was. But rising interest rates have left the system vulnerable. 

As the chart below shows, the proportion of securities to deposits was particularly high at SVB. More than 70% of client deposits were invested in securities (instead of consumer loans, for instance). And the bulk of those securities was made up of treasuries, which are seen as very safe when held until maturity, but where the owner can (and SVB did) incur heavy losses when forced to sell before maturity, for instance because of a bank run. 

While the problems on the asset side are more or less of SVB’s own making and a clear sign of weak or non-existent risk management, there are also problems on the equity-and-liabilities side of many banks’ balance sheets. And these problems might become an issue for the banking sector as a whole, in particular the regional banks (which by the way is the reason why we have kept our exposure to the banking sector to a minimum).  

With short-term rates rising, banks have to pay more to their clients on their deposits as otherwise any CFO worth his salt will already start withdrawing cash out of regional banks and shift it to a systematically important bank (or at least start the account opening process).  However, from 2020 to 2022, 40 percent of mortgage loans in the US were financed or refinanced for the next 5-10 years at 1-2%. A lot of the corporate bonds were also refinanced for the next 3-5 years at low rates as well.   

We are concerned about this ‘systemic asset-liability mismatch’ and that the business model for many US banks might be “broken”. After the ‘hot run’ on the deposits of SVB, there might be a ‘slow run’ on other regional banks. The survivors might be the big banks, where there are no concerns about the safety of deposits.  

It would be detrimental to the price level if rates stay too low. But it would be detrimental to the banking sector if rates go too high. The Federal Reserve should probably tread very carefully.