Jake Miller
The US banking system has been fragile in recent years, with a series of bank failures and bankruptcies occurring in early 2023. Over five days in March 2023, three small-to-midsize banks collapsed, triggering a sharp decline in global bank stock prices. These failures have raised concerns about the stability of the US banking system and the potential impact on customers and communities. While some banks exhibit warning signs of failure, such as unrealized losses and heavy reliance on uninsured deposits, the overall number of bank failures has decreased since 2019. The federal government and the Federal Reserve have intervened to mitigate the fallout and provide liquidity to the financial system. However, the vulnerability of banks has implications for financial stability and the conduct of monetary policy.
| Characteristics | Values |
|---|---|
| Date of search | 1st May 2024 |
| Number of banks that failed in 2023 | 3 |
| Names of banks that failed in 2023 | Silicon Valley Bank (SVB), Signature Bank, First Republic |
| Reason for failure | SVB: run by uninsured depositors, large holdings of government bonds lost value; Signature Bank: shift in portfolio to longer-maturity bonds; First Republic: majority of long-term assets in municipal bonds |
| Number of banks at higher risk of failure | ~300 |
| Names of banks at risk of failure | Republic First Bank |
| Reason for risk of failure | Unrealized losses on investment securities, heavy reliance on uninsured deposits |
| Number of banks that failed since 2019 | 15 |
| Names of banks that failed since 2019 | Resolute Bank, First National Bank of Lindsay, Pulaski Savings Bank |
| Reason for failure | Suspected fraud |
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What You'll Learn
Unrealized losses on investment securities
The collapse of two of the largest US banks in March 2023 has raised concerns about the stability of the US banking system and the potential for more bank failures. While there are various reasons for bank failures, one significant factor is unrealized losses on investment securities.
The rise in interest rates over the past few years has adversely affected the market value of banks' securities portfolios, leading to significant unrealized losses. As of April 2023, these unrealized losses exceeded $550 billion, or about 30% of regulatory capital. The impact of these losses on banks' financial health is analyzed by tools such as the US Banks' Unrealized Losses on Investment Securities Screener, which assesses the exposure of banks with over $1 billion in assets to potential losses on their investment securities portfolios.
The consequences of unrealized losses for banks are significant. Firstly, they increase the risk of a cash shortfall if banks face unexpected liquidity needs. To address this, banks may be forced to tap into capital market financing, such as issuing long-term debt or equity, which can lead to higher funding costs as investors demand larger risk premia. Secondly, as asset values decline, investors perceive banks as riskier, potentially leading to a loss of confidence in the banking system. This reduced confidence can result in depositors withdrawing their money, as seen in the case of Silicon Valley Bank (SVB), where a run by uninsured depositors contributed to the bank's collapse.
To summarize, unrealized losses on investment securities have contributed to the fragility of US banks and remain a critical factor that could potentially trigger more bank failures. The impact of these losses on banks' financial stability and the potential risk of insolvency highlight the need for proactive measures to safeguard the US banking system and maintain depositor confidence.
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Heavy reliance on uninsured deposits
The failure of Silicon Valley Bank (SVB) in 2023 has brought to light the risk factors that could lead to the collapse of other banks in the country. One of the primary reasons for SVB's collapse was its heavy reliance on uninsured deposits.
SVB's failure was triggered by a run on deposits, where depositors quickly withdrew their uninsured money upon learning of the bank's investment-related balance sheet problems. This resulted in significant withdrawals that ultimately led to the bank's collapse within two days. SVB had a disproportionately large share of uninsured funding, with 78% of its assets funded by uninsured deposits.
Uninsured deposits pose a significant risk to the stability of banks. When a bank fails, uninsured depositors may lose their money, causing a knock-on effect on other banks, especially in a stressed economic environment. This is further exacerbated by the fact that system-wide, uninsured depositors make up about half of bank deposits.
To address these risks, banking regulators need to carefully consider the implications of policy changes designed to reduce reliance on uninsured deposits. Regulators should also ensure that banks are prepared to use the Federal Reserve's discount window when deposit outflows exceed expectations, to avoid the unnecessary tightening of credit. Additionally, banks whose uninsured deposits exceed a certain threshold should be required to provide regulators with detailed data on these deposits to facilitate assessments of their stability.
The Federal Deposit Insurance Corporation's (FDIC) response to the SVB failure, where they guaranteed all deposits, has also raised concerns about moral hazard. Banks may become unconcerned about the potential flight of uninsured deposits and take on more risk in loans and other assets. This could lead to excessive risk-taking and potentially threaten the stability of the entire U.S. banking system.
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Banks' assets and capitalization
The stability of banks is closely tied to their assets and capitalization. A bank can become insolvent if its asset values are less than its liabilities. This was the case with SVB, which collapsed within two days due to a run by uninsured depositors. The bank had a disproportionately large share of uninsured funding, with 78% of its assets funded by uninsured deposits.
The market value of a bank's assets is crucial. If the market value of a bank's assets is lower than their book value, the bank may not be able to cover both insured and uninsured deposits in the event of a run. This discrepancy can lead to insolvency and threaten the stability of the entire banking system.
Unrealized securities losses in banks have reached $478 billion, and 40 banks with over $1 billion in assets have reported unrealized security losses greater than 50% of their equity capital. A large number of smaller banks have also reported significant losses.
Historically, the amount of capital held by banks has been influenced by factors such as the ease of raising capital, bankers' choices, and supervision and regulation. In the late 19th and early 20th centuries, aggregate capital positions at US banks were generally in decline. This trend shifted during the prosperous 1920s, when raising capital was more affordable, but the trend reversed during the 1930s depression, when capital became more expensive.
To address concerns about bank capital positions, uniform and specific capital standards were developed in the 1980s. These standards have since been refined multiple times, including major revisions after the 2007-2009 financial crisis. Regulators have also implemented minimum capital-to-asset requirements to strengthen banks' financial positions.
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Monetary policy tightening
The Federal Reserve's monetary policy tightening in the form of rate hikes between early 2022 and mid-2023 has had a significant impact on US banks. The Fed increased the federal funds rate by nearly 4.5 percentage points during this period, leading to a $2.2 trillion decline in the market value of long-term bank assets. This has raised concerns about the stability of the US banking system and the risk of bank failures.
One of the key factors affecting banks' stability is their exposure to uninsured deposits. Uninsured deposits account for about half of all bank deposits and approximately $9 trillion of aggregate bank funding. When interest rates increase, the market value of banks' assets declines, and uninsured depositors may have incentives to withdraw their funds, potentially leading to "runs" on banks. This is particularly relevant for banks with high asset losses, low capital, and a high proportion of uninsured deposits.
The failure of Silicon Valley Bank (SVB) in March 2023 following a sharp tightening of monetary policy has been cited as a case study. While SVB's asset losses were not unusual, it had a disproportionately large share of uninsured funding, with 92.5% of its deposits being uninsured. This led to significant withdrawals and the bank's collapse within two days. The risk of bank failure due to monetary tightening is not uniform across the US, with higher exposure in regions with more minorities and lower-income households.
To maintain price stability, promote maximum sustainable employment, and provide moderate long-term interest rates, the Fed has a mandate to manage monetary policy. The Fed's actions can influence the cost of consumer debt such as mortgages, credit cards, and loans. While the Fed's recent focus has been on keeping inflation in check, it has also been monitoring labour market data and economic activity to inform future rate decisions.
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Banks' liquidity
Banks can fail for many reasons, but generally, they fall into a few broad categories: a run on deposits, too many bad loans or assets that fall precipitously in value, or a mismatch between what the bank can earn on its assets and what it must pay on its liabilities. In the case of Silicon Valley Bank (SVB), the bank's large holdings of government bonds lost value as the Federal Reserve rapidly hiked interest rates. Simultaneously, as funding for startups became scarcer, more SVB customers began withdrawing their money. SVB's failure was largely attributed to a run by uninsured depositors, with 92.5% of its deposits being uninsured.
Bank liquidity refers to the cash and other liquid assets that banks have available to quickly pay bills and meet short-term business and financial obligations. Liquid assets are those that can be converted to cash quickly to meet financial obligations, such as central bank reserves and government bonds. Bank liquidity regulations typically focus on an individual bank's ability to quickly convert assets into cash, known as its liquidity position. A bank's liquidity coverage ratio is the ratio of high-quality liquid assets over its estimated 30-day net cash outflows, indicating its ability to meet cash demands during stressful periods.
During the COVID-19 pandemic, liquidity shocks to individual banks impacted the liquidity positions of other banks, with connections transmitting risks between banks being stronger during this period. A liquidity shock to one bank can ripple across a network of firms, especially during crises, potentially compromising the stability of the entire financial system. For example, in Argentina, higher reserve requirements and interest rates imposed by the government triggered a liquidity crunch, driving up funding costs for banks and threatening their profitability.
In the context of US banks, the Stanford Institute for Economic Policy Research (SIEPR) found that the market value of the US banking system's assets is $2.2 trillion lower than their book value. This discrepancy could lead to insolvency and threaten the stability of the US banking system if a run on these banks were to occur. Additionally, about 40 banks with over $1 billion in assets have reported unrealized security losses greater than 50% of their equity capital, indicating a higher risk of failure.
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Frequently asked questions
Banks can fail for many reasons, including a run on deposits, bad loans, or assets that fall in value, eroding the bank's capital reserves. A mismatch between what the bank can earn on its assets and what it has to pay on its liabilities can also cause failure.
Three small to mid-size US banks failed over five days in March 2023, causing a sharp decline in global bank stock prices. The Federal Reserve intervened with the Bank Term Funding Program (BTFP), an emergency lending program to prevent a wider crisis.
Unrealized losses on investment securities and a heavy reliance on uninsured deposits were common warning signs. A large number of banks reported unrealized security losses greater than 50% of their equity capital.
The failure of a bank can have indirect consequences for communities and customers. This may include reduced investment in new branches, technological innovations, or staff. It can also lead to direct consequences if depositors have amounts over the insured deposit limit, which is $250,000.
