Megan Brooks
The US banking system has been in a fragile state in recent years, with a number of banks collapsing since 2019. In 2023, the US experienced a banking crisis, with the collapse of Silicon Valley Bank and Signature Bank, the shutdown of Silvergate Capital, and the sale of Credit Suisse. This crisis was caused by a combination of factors, including the COVID-19 pandemic, rising interest rates, and a decline in bond prices, which led to a decrease in the market value of bank capital reserves. This resulted in a bank run as customers withdrew their funds, causing further instability in the banking system. With a history of bank failures and the recent turmoil in the industry, the question of whether US banks are in trouble is a pressing one.
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What You'll Learn
The impact of the 2021-2023 inflation surge
The 2021–2023 inflation surge in the United States had a significant impact on the country's banking sector, leading to a crisis in 2023. During this period, the Federal Reserve Bank raised interest rates to curb inflation, which had a detrimental effect on banks with high levels of exposure to long-term assets, such as US Treasury bonds.
As interest rates rose, the market value of these bonds decreased, leading to significant losses for banks that had invested heavily in them. This was particularly true for banks with low capital levels and a high ratio of uninsured deposits to assets. In response to the decline in the value of their assets, some banks sold their bonds, realizing steep losses.
The increase in interest rates also raised borrowing costs throughout the economy, affecting the liquidity of some businesses and individuals. This, in turn, led to a bank run at Silicon Valley Bank (SVB) as customers withdrew funds totaling US$42 billion in a single day. SVB had a high proportion of uninsured deposits, and despite its liquid balance sheet, it collapsed within two days due to the run.
The failure of SVB, along with that of Silvergate Bank and Signature Bank, prompted regulators to step in with a rescue plan for depositors and other affected institutions. Moody's Investors Service downgraded its outlook on the US banking system to "negative," reflecting the deteriorating operating environment.
The impact of the inflation surge and subsequent interest rate hikes extended beyond the banks themselves, with investors also showing decreased confidence in the sector. There was a general mood of distrust towards banks, and investor outflows from regional and smaller banks totaled nearly $1 billion in the six months leading up to September 2023. The regional banking crisis of March 2023 continued to affect investor sentiment towards bank stocks, even six months later.
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The role of cryptocurrency
While there are several factors that could be contributing to the trouble US banks are facing, one of the key concerns is their exposure to solvency runs. When monetary policy tightens, as it did in response to high inflation in 2022, banks become vulnerable to asset declines. This is because banks invest in long and short-maturity assets, and when monetary policy tightens, long-dated assets experience significant value declines.
In addition, interest rate increases can lead to bank runs, even when banks have liquid assets. This is because uninsured depositors may pull their funds, believing that others will do the same, creating a self-fulfilling prophecy. Banks with low capital levels and a high ratio of uninsured deposits to assets are the most vulnerable to insolvency.
The rise of cryptocurrency is also having an impact on traditional banking. Cryptocurrency was created as an alternative to traditional banking infrastructure, allowing for peer-to-peer transactions without a regulated intermediary. This lack of centralisation undermines the authority of central banks, and the pseudonymity of transactions raises concerns about anti-money laundering regulations and know-your-customer protocols. However, regulatory agencies like the Office of the Comptroller of the Currency (OCC) are trying to encourage banks to embrace digital currencies, recognising their potential to drive innovation and efficiency in the financial sector.
Despite initial wariness, some major banks are now actively engaging with cryptocurrency. For example, Goldman Sachs has offered loans to wealthy clients based on their crypto holdings, and banks like JPMorgan and Bank of America are exploring the development of fresh cryptocurrencies under their umbrellas. Regulatory changes, such as the GENIUS Act, have also created pathways for banks to operate in stablecoins tied to the US dollar, which could help to stabilise the volatile price of cryptocurrencies.
While the decentralised nature of cryptocurrency may pose a threat to traditional banking, banks can also benefit from partnering with this emerging industry. By adding assurance and security to the largely unregulated crypto environment, banks can play a significant role in the crypto space.
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Interest rate increases
Challenges for Banks
The sharp increases in interest rates have created several challenges for banks in the US:
- Increased funding costs: Rising interest rates have led to higher funding costs for banks, impacting their profitability. This is particularly true for banks with a high reliance on uninsured deposits, as seen with the collapse of Silicon Valley Bank.
- Loan delinquency: Higher interest rates can make it challenging for borrowers to make loan payments, resulting in increased loan delinquency rates. This has prompted banks to set aside more funds to cover future credit losses.
- Impact on fixed-rate securities: The increase in interest rates has lowered the value of investment securities held as assets, making it problematic for banks to sell these securities without realizing losses.
- Credit quality concerns: Examiners are closely monitoring banks with significant commercial real estate (CRE) portfolios due to concerns about credit quality in a rising interest rate environment, especially with the decline in demand for office space related to remote work.
- Deposit pricing pressure: Some banks experienced deposit pricing pressure in 2023, making it challenging to adjust to the changing rate environment.
- Vulnerability to runs: Banks with smaller initial capitalizations, higher uninsured leverage, and a higher proportion of sophisticated depositors are more vulnerable to panic-induced runs as interest rates rise.
Opportunities for Banks
Despite the challenges, the interest rate hikes also present some opportunities for banks:
- Improved earnings: The Federal Reserve's monetary tightening can help ease the downward pressure on net interest margins that banks have faced due to increased competition and low interest rates. As rates charged on loans increase, banks may improve their earnings.
- Increased profitability: Large banks have reported increased profitability in their interest rate-sensitive operations, with asset yields rising more than funding costs.
- Enhanced capital positions: Some banks may benefit from the higher interest rates, improving their capital positions.
Regulatory Response
The situation has prompted discussions about the regulatory response to ensure the stability of the US banking system. Regulators could adopt methodologies to stress-test the banking system for higher interest rate scenarios, considering both assets and liabilities. Additionally, there may be a need for enhanced financial sector regulation and supervision to address fragilities within the system.
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Fraud and scams
To combat fraud, banks must continuously invest in advanced technologies and implement robust security measures. Multi-factor authentication, encryption, and secure access controls are essential for protecting consumer accounts. Additionally, consumer education and awareness play a crucial role in preventing fraud. Consumers should stay informed about the latest scam techniques and recognize common red flags, such as unsolicited requests for personal information or urgent demands for payment. Being attentive and cautious during financial transactions can help reduce the risk of falling victim to scams.
While banks have a responsibility to safeguard against fraudulent activities, consumers also have a role in protecting themselves. This includes practicing good password hygiene, shielding PIN entries in public, and not sharing login credentials with others. By combining advanced security measures with consumer education and awareness, the impact of fraud and scams on banks and their customers can be mitigated.
It's important to note that certain groups, such as the elderly, may be more vulnerable to specific types of scams, including romance scams, tech support scams, and government impersonation scams. Scammers exploit emotions and trust to deceive individuals and gain access to their financial information. Public awareness campaigns and educational initiatives tailored to different age groups can help empower individuals to recognize and avoid potential scams.
To address scam-induced fraud losses effectively, a collaborative effort is required between consumers, financial institutions, and regulators. Regulatory bodies play a crucial role in defining responsibilities and enforcing accountability. By working together, implementing advanced security measures, and promoting consumer awareness, the impact of fraud and scams on banks and consumers in the US can be significantly reduced.
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The impact of the Federal Reserve's monetary policy
The Federal Reserve's monetary policy has had a significant impact on the stability of banks in the US. The Fed's policy tools include changing the target for the federal funds rate, large-scale asset purchases (quantitative easing), and forward guidance. The Federal Open Market Committee (FOMC) sets a target interest rate policy for the federal funds rate, which is the rate at which banks borrow and lend excess reserves overnight. By raising or lowering this rate, the Fed can impact underlying economic conditions. For example, during high inflation, the FOMC raises interest rates to make borrowing more expensive and slow down economic activity, thereby reducing inflation.
The Fed's monetary policy decisions are made with a focus on achieving long-term goals, based on data and objective analysis, while remaining adaptable to changing economic conditions. The Fed's independence from Congress allows it to make decisions in the best interests of the American people, while also being accountable through transparent communications and testimonies before congressional committees.
However, the impact of the Fed's monetary policy tightening in response to high inflation has had unintended consequences for banks. A study by the Stanford Institute for Economic Policy Research (SIEPR) found that interest rate increases can lead to bank runs, even when banks have liquid assets. This occurs when uninsured depositors withdraw their funds, creating a self-fulfilling prophecy of negative expectations. The model identified fragile banks as those with low capital levels and a high ratio of uninsured deposits to assets. The study estimated that almost 190 banks with assets of $300 billion are at risk of impairment due to withdrawals by uninsured depositors.
Additionally, the Fed's monetary policy has implications for the labour market. Higher interest rates can lead to weaker hiring activity, as businesses may absorb tariff costs instead of passing them on to consumers. This could result in a slower economic growth rate. As a result, the Fed must carefully consider the potential impact of its policies on both inflation and employment, weighing the risks and benefits of different interest rate decisions.
In conclusion, the Federal Reserve's monetary policy has a significant impact on the stability of banks in the US. While the Fed's decisions aim to promote economic stability and control inflation, they can also inadvertently create challenges for banks and the labour market. The Fed must navigate these complexities to ensure that its policies effectively serve the interests of Americans and maintain a stable financial system.
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Frequently asked questions
Yes, banks in the US are currently in trouble. In March 2023, two of the largest US banks collapsed, leading to a wider banking crisis.
The crisis was caused by a combination of factors, including rising interest rates, declining bond prices, and a decrease in the market value of bank capital reserves.
Silicon Valley Bank (SVB), Signature Bank, and Silvergate Capital all failed during this crisis. SVB and Signature Bank collapsed in rapid succession, while Silvergate Capital voluntarily shut down.
The initial three bank failures put pressure on other US regional banks and reduced available financing in the commercial real estate market. It also led to a slowdown in commercial property development. There were also inter-bank flows of funds to shore up bank balance sheets.
The Federal Deposit Insurance Corporation (FDIC) provides insurance for customer deposits at banks, savings-and-loans, and similar institutions. The FDIC’s BankFind tool offers data on failed banks, going back to 1934. Additionally, the Federal Reserve and other central banks have implemented liquidity measures to calm market turmoil.
