Hailey Johnson
The collapse of Silicon Valley Bank and Signature Bank in 2023, two of the largest bank failures in US history, sent shockwaves through the industry. Since then, there has been growing concern about the stability of the banking sector. A report by the Social Science Research Network found that 186 banks in the US are at risk of failure due to rising interest rates and a high proportion of uninsured deposits. Finance experts at Florida Atlantic University also warn that over 60 of the largest banks in the country are at an increased risk of failure due to their commercial real estate exposures. With banks already failing and hundreds more at risk, the potential impact on the economy could be significant.
| Characteristics | Values |
|---|---|
| Number of banks at risk of failure | 186 |
| Number of banks with exposure to commercial real estate greater than 300% of their total equity | 67 |
| Number of banks with total CRE exposures greater than 300% | 1,871 |
| Number of banks with exposures greater than 400% | 1,112 |
| Number of banks with exposures greater than 500% | 551 |
| Number of banks with exposures greater than 600% | 243 |
| Number of banks facing similar risks due to their commercial real estate exposure and having less than $10 billion in total assets | 60+ |
| Number of banks facing dual threats of commercial real estate loans and potential losses tied to higher interest rates | 282 |
| Number of banks that have failed from 2001 to 2024 | 567 |
| Largest bank failures in US history | Silicon Valley Bank, Signature Bank |
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What You'll Learn
Uninsured deposits
The failures of Silicon Valley Bank (SVB) and Signature Bank in 2023 have brought attention to the risks associated with uninsured deposits. In the case of SVB, its rapid failure was linked to its significant reliance on uninsured deposit funding from the technology and VC sector. Similarly, Signature Bank's collapse was attributed to weaknesses in corporate governance, highlighting the importance of effective risk management.
While not all banks with a high proportion of uninsured deposits are equally vulnerable to runs, it is crucial to assess the historical and projected instability of these deposits. Some small and large banks are heavily dependent on uninsured deposits, and a failure could result in losses for uninsured depositors, potentially triggering runs on uninsured deposits at other banks.
To address this, the FDIC has the systemic risk exception, which allows them to protect depositors beyond the insured portion in extraordinary circumstances. This involves a rigorous process, requiring approval from the Secretary of the Treasury and the President, among others. Additionally, banks can protect themselves by maintaining diverse primary and secondary funding sources to manage funding stress related to uninsured deposits.
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Commercial real estate exposure
Commercial real estate (CRE) exposure is a significant risk factor for bank failure. Finance experts at Florida Atlantic University (FAU) have warned that more than 60 of the largest banks in the US are at an increased risk of failure due to their CRE exposures. According to FAU's US Banks' Exposure to Risk from Commercial Real Estate screener, 67 banks have CRE exposure greater than 300% of their total equity, which is considered excessive and puts them at a greater risk of failure.
The high level of CRE exposure in banks is due to the nature of CRE mortgages. Most CRE mortgages are five- or ten-year balloon mortgages, which means that a large number of loans are currently rolling over and need to be refinanced at much higher rates. In addition, the demand for office space has decreased significantly since the pandemic, resulting in high office vacancies and lowering returns on investment in commercial properties. This has exposed vulnerabilities in the banking system, as hundreds of billions of dollars in CRE loans are coming due.
The combination of rising interest rates and decreasing demand for office space has resulted in a high-interest-rate environment, making it difficult for banks to reprice CRE loans. As a result, there is a growing concern that these properties will no longer be cash flow positive, and banks will be forced to write down their CRE exposures. This could lead to a situation where depositors pull their money out of highly exposed banks, triggering a banking panic similar to what occurred in the spring of 2023.
While it is challenging to quantify the impact of CRE exposures on the banking system, experts agree that some banks will likely fail, particularly in regions like the Northeast and California, where office vacancies remain high due to remote work trends.
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Rising interest rates
Additionally, banks invest in bonds and other debt securities, which lose value when interest rates rise. If faced with sudden deposit withdrawals or funding pressures, banks may be forced to sell these securities at a loss. This was evident in the case of Silicon Valley Bank, where a combination of rising interest rates and uninsured deposits led to the bank's failure. The bank's assets lost value due to the rate increases, prompting worried customers to withdraw their uninsured deposits, ultimately resulting in the bank's closure.
The impact of rising interest rates on banks is not uniform across the industry. Smaller banks, particularly those with high levels of uninsured deposits, are more vulnerable. A report by the Stanford Institute for Economic Policy Research (SIEPR) identified almost 190 banks with assets of $300 billion at potential risk of insolvency due to rising interest rates and the withdrawal of uninsured deposits. Additionally, regions with more minorities and lower-income households are at higher exposure to the risk of bank failure.
To address these challenges, regulators and bank management need to increase their focus on the banking industry's IRR (Interest Rate Risk) exposure. While some banks may be well-positioned to benefit from higher interest rates, improving their earnings and capital positions, others may struggle. Examiners are closely monitoring banks with significant interest rate risk exposures and conducting targeted exams on deposit trends, funding sources, and the value of investment securities.
In conclusion, rising interest rates pose a significant risk to banks, particularly those with high levels of uninsured deposits and vulnerable economic regions. The impact of rising interest rates on the banking industry underscores the importance of careful risk management, diversification of funding sources, and proactive regulatory responses to ensure the stability and resilience of the financial system.
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Unrealized investment losses
Banks hold investment securities, and significant drops in their value can erode a bank's capital base, leading to unrealized investment losses. These losses occur when the market value of a security decreases but the bank has not yet sold it at a loss. During the pandemic, bank loan demand decreased sharply, and banks were left with high cash balances. In response, they purchased long-maturity, government-backed debt instruments, which offer higher returns than shorter-maturity options. However, as interest rates rise, bond prices tend to fall, and banks face the risk of cash shortfalls.
To address liquidity needs, banks may be forced to issue longer-term debt or equity, but this can lead to higher funding costs as investors demand greater returns. As asset prices decline, bank risk increases, and the potential for unrealized losses becomes more significant. These losses can impact a bank's decision-making, as seen in the case of Silicon Valley Bank, which experienced a run on deposits after announcing its intention to raise additional capital due to securities losses.
Unrealized losses on investment securities can have a substantial impact on a bank's financial health. The U.S. Banks' Unrealized Losses on Investment Securities Screener analyzes over 1,000 U.S. banks with assets exceeding $1 billion to assess their exposure to unrealized losses. This analysis is essential for understanding the potential consequences for banks and borrowers. Additionally, the Federal Reserve Bank of Kansas City has published studies exploring the implications of unrealized losses for banks, highlighting the risks associated with interest rate changes and their impact on banks' decision-making and financial stability.
While banks may classify securities as "held-to-maturity" or "available-for-sale", unrealized losses on both types of securities can affect their equity levels. Florida Atlantic University's ongoing quarterly project, sponsored by Executive Education, calculates losses on these securities and their impact on regulatory capital. This project provides valuable insights into the risks faced by banks with significant investment portfolios.
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Inconsistent federal regulation
The inconsistent application of non-capital measures, such as liquidity and risk-management practices, has been cited as an area for improvement. For instance, while Silicon Valley Bank and Signature Bank exhibited strong capital measures before their collapse, non-capital indicators may have provided an earlier warning of their financial health issues. Regulators sharing their findings and concerns at the end of examinations is a positive step, but inconsistencies across federal regulators in these efforts have been noted.
Differing perspectives among regulators on how to discourage inappropriate risk-taking have also hindered the finalization of recommendations. This delay in regulatory action could have far-reaching consequences, as bank failures can trigger a domino effect, causing a credit crunch and slowing economic growth. It can also lead to a loss of confidence in the banking system, potentially resulting in a financial crisis.
To address these issues, Congress has been advised to mandate that regulators adopt non-capital measures to better identify risks and implement preventative actions. Additionally, the Federal Reserve should expedite the finalization of rules aimed at facilitating earlier remediation of issues within financial institutions. By enhancing the consistency and timeliness of regulatory responses, the resilience of the banking sector can be strengthened, mitigating the risk of future failures.
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Frequently asked questions
Yes, hundreds of small and regional banks across the U.S. are facing financial stress. A report from the Social Science Research Network found that 186 banks in the U.S. are at risk of collapse due to rising interest rates and a high proportion of uninsured deposits.
Banks with high exposure to commercial real estate (CRE) are at an increased risk of failure. Over 60 of the largest banks in the U.S. fall into this category, with CRE exposures greater than 300% of their total equity. Additionally, banks that rely heavily on uninsured deposits exceeding FDIC insurance limits are more vulnerable to failure if a crisis occurs.
If a bank fails, depositors may rush to withdraw their funds, causing a bank run. This could lead to a broader panic and a loss of confidence in the banking system, potentially triggering a recession or financial crisis. Federal deposit insurance can provide some protection, ensuring that depositors are compensated up to certain limits.
To prevent bank failures, regulators need to improve oversight and address gaps in risk management practices. Noncapital measures, such as liquidity and risk management, can provide early warning signals, giving banks more time to address financial health issues. Implementing regulations to promote the early remediation of issues at financial institutions is also crucial.
