Why Are Banks Failing Again? Part 2
Time to Reimpose Tough Rules on Regional Banks
We explained Silicon Valley Bank’s abrupt collapse in Part One of this article. In this section we will analyze how its failure jeopardized First Republic Bank, and we will propose measures to reduce the chances of another bank run.
First Republic: The Good…but Swamped
The terrifying aspect of bank runs is how easily they can spread, as panicked investors flee other institutions, even ones that are basically sound. Once customers lose confidence, and the rumor mill gets going, a bank can face a staggering outflow of deposits, regardless of its true condition. Banks are not built to withstand this kind of financial tsunami.
As SVB teetered, the contagion spread to First Republic Bank, a well-managed bank with a strong franchise. First Republic operates like a “private bank”, catering to businesses and wealthy individuals and providing a very high level of service.
Like SVB On The Surface…
At first glance, First Republic has a similar profile to SVB’s. First Republic also has about $200 billion of assets. Based in San Francisco, the bank naturally has many tech-oriented customers, but its clientele is much more diversified than SVB’s. The bank has had a high percentage of uninsured deposits, too, which partly reflects its focus on commercial clients, such as real estate developers and law firms.
First Republic has also incurred significant mark to market losses on its bond portfolio, but to a lesser degree than SVB. The bank’s unrealized losses were about $5 billion as of year-end 2022, the latest figures available. That represented about 30% of its equity, rather than the almost total wipeout for SVB. The embedded losses may well have increased during 2023, though.
In any event, the bank’s customers grew afraid that First Republic might also have to sell down its bond portfolio to redeem their deposits. First Republic lost vast amounts of its deposits within a few days, threatening its survival. A group of banks led by JPMorgan stepped in to assist the bank, with the encouragement of Treasury Secretary Janet Yellen. They provided $30 billion of funding for First Republic to help offset the deposit outflow.
Why would competitors want to rescue First Republic? The banks and the government wanted to stabilize the overall banking landscape. In addition, First Republic has a large commercial real estate (CRE) portfolio. Many real estate developers are already struggling to get financing, because of the high vacancy rates in cities. If yet another large CRE lender collapsed, that would compound the industry’s woes.
What Should Congress Do?
In an ideal world, Congress would promptly reverse the regulatory rollbacks that the Trump Administration pushed through. In hindsight, reducing bank regulation for large regional banks in 2018 was a mistake.
But bank executives have already geared up to fight any move to tighten the rules. As always, they claim that the increased regulatory costs will create an undue burden on their institutions, restrain lending, and hurt the economy.
Well, SVB’s failure has been expensive, too. The bank’s collapse will cost the FDIC over $20 billion. That would pay for a lot of red tape. The government plans to pass that burden onto the mega-banks and other large regional banks, by raising the fees they pay to the FDIC.
Furthermore, SVB’s demise will have important indirect effects because tech start-ups will find it harder to get financing. A further slowdown in tech will affect the U.S. economy.
In any case, the Republican House leadership seems intent on blocking any moves to tighten bank regulation.
Raising The FDIC Limit
Here’s what Congress must do now: raise the FDIC deposit insurance limit to $1 million. A higher limit would help to reassure skittish depositors and forestall any additional bank runs. Although the FDIC can raise the limit temporarily, Congress has the authority to mandate permanent increases in deposit insurance coverage.
In this instance, bank executives are likely to support new legislation, rather than oppose it. Most will probably accept the tradeoff of paying higher FDIC fees in return for a stable banking environment.
No More Talk About “Bailouts”
There is a lot of misleading talk, in Congress and the press, about “bailing out rich depositors” at SVB and perhaps other banks. These comments echo the misguided complaints about “bailing out the banks” in 2008–09, which prevented the U.S. from falling into a depression.
As we have discussed, many of SVB’s deposits represented the funds raised by start-ups to finance their operations. They were not cash balances left lying around by Silicon Valley fat cats.
Most people and businesses park their cash at a bank for convenience and safety. They are not trying to make a high return. SVB has been paying the same low rates on deposits as other banks do. Most depositors, except for large companies, do not have the time or expertise to do a full-blown credit analysis of their bank. They should not have to.
After the financial crisis and the Dodd-Frank reforms, bank investors understand that the government will not bail them out. SVB’s equity investors and bondholders have been wiped out. That’s as it should be. Unlike depositors, these investors do extensive research and pick companies to make money.
Back To A Tougher Fed
Chair Powell and other Fed officials are clearly chagrined by this latest banking crisis and the glaring mistakes in bank supervision. Michael Barr, the vice chair of supervision, is taking a hard look at what went wrong and will publish a report in May.
In the meantime, here are some suggestions.
The Fed should require banks with more than $100 billion in assets to undergo stress tests every year. The agency has the discretion to do that, without asking Congress for approval.
In the stress tests, banks should show how a sharp rise or fall in interest rates could affect their bond portfolios…and what they are doing to mitigate that risk.
Beyond the formal, annual review, bank supervisors should frequently discuss with regional banks how they are managing their portfolios’ exposure to interest rate shifts…just as the regulators do with the mega-banks.
The Fed should reconsider the practice of having bank executives serve on the regional Fed banks’ boards. In the past, board members have undoubtedly benefited from bank executives’ expertise and market insights. However, board members could also obtain those insights through periodic meetings with bank executives, even if they no longer serve on the board.
Banking crises are a fact of life in our dynamic, capitalist society. It’s time to take some reasonable steps to limit the damage from the next blow-up.
