On March 10, 2023, SVB Financial Group (Silicon Valley Bank), serving high tech startups and their owners, suffered from a serious bank run and was closed by California regulators. A few days earlier, Silvergate Financial, a bank catering to crypto asset clients, was unable to meet deposit withdrawals and voluntarily wound down its business. On March 12, the regulators also closed Signature Bank in New York, which has been active in crypto asset trading.
At the same time, the Fed announced a new Bank Term Funding Program (BTFP) designed to lend to banks and other depository institutions for up to one year against high quality collateral such as US Treasuries, agencies, and mortgage backed securities, at their face values instead of market values. The BTFP will be backstopped by $25 billion from the Treasury’s Exchange Stabilization Fund (ESF)—in addition to the Federal Deposit Insurance Corporation (FDIC) fund of $125 billion, which has been paid in by banks as insurance premiums.
They also emphasized that all depositors at the two closed banks will have access to their deposits. Presumably, the closed banks have sufficient collateral to borrow from the new program to pay off all depositors. However, it is highly likely that share and bond holders will have to take haircuts in the resolution of the closed banks. Prompt actions by regulators enable startup companies to have access to their deposits at SVB to continue functioning. But they have failed to stabilize financial markets in the United States and globally.
The launch of the BTFP aims to help banks make full use of their US Treasury portfolios—without realizing mark-to-market losses—in order to payoff large depositors exceeding the $250,000 FDIC limit per account, per bank. The BTFP thus buys time for the Treasury collateral to regain par value at their maturity, allowing the authorities to claim that taxpayer money will not be involved in the resolution of the failed banks. Nevertheless, “buying time” represents rescuing banks from the marked-to-market losses on their high-quality bond holdings; and the public fund from the ESF is being used as a back-up. As a result, there will likely be criticism and protests from politicians opposed to bank bailouts following the 2008 financial crisis.
The announced emergency measures have failed to stabilize markets, with participants now looking for the Fed to ease off on its tightening regime, which is the root cause of the difficulties at the failed banks. Fed action remains to be seen, but events in the past week have already raised important questions which have to be addressed going forward.
Most immediately, what will happen if a bank under liquidity pressure does not have enough high-quality bonds to use as collateral—even at par value—to borrow money to pay off large depositors? Will the Fed relax the current rules and allow the BTFP to accept less than high-quality bonds (such as corporate bonds) as collateral. Will it require large depositors to accept less than their full amount? This uncertainty will keep depositors on edge and encourage at least some of them to move to strong banks in a flight to quality.
Secondly, the efforts to protect large depositors have put the US banking system on a slippery slope of socializing the deposit-taking business of banks, creating huge moral hazard. The risk is that, under the pressure of financial market turmoil and business disruptions, authorities will keep relaxing the conditions for lending to failing banks to help them pay off all depositors. It is important to realize that protecting all bank deposits would be hugely costly either in terms of necessary insurance premiums charged to banks or using public funds. Ideally, a clear limit for deposit insurance protection needs to be drawn. Above this limit, large depositors will need to be paid only from the liquidation proceeds of their failed banks. A precedent for this is the case of IndyMac, which failed in 2008. Its large depositors took a 50 percent haircut at that time, and were required to wait for potential residual payments later on.
Thirdly, authorities need to explore ways to minimize the detrimental effects of marked-to-market losses on the huge volume of bonds held by banks and other financial institutions during the long period of near-zero interest rates. The FDIC has estimated that unrealized losses on those bond holdings amounted to $620.4 billion at the end of 2022—more than doubling US banks’ net income of $263 billion in 2022. Presumably the unrealized losses would weigh more heavily on banks with inadequate risk management practices. However, while hedging can reduce interest rate risks—and losses—of individual banks, the risk and potential loss remain in the whole banking system.
Banks can put a portion of their bond holdings in “held to maturity” (HTM) accounts, in which case those positions don’t need to be marked to market. The theoretical marked-to-market losses on the HTM accounts amount to about $300 billion but will be protected by the BTFP. If banks put them in “available for sale” accounts, they must be marked-to-market and the resulting valuation losses charged against equity capital. As mentioned above, US banks—especially the systemically important ones—are better capitalized (with Tier 1 risk-based capital ratio of 13.65 percent at the end of 2022) compared to the 2008 situation. They can therefore absorb these valuation losses. Nevertheless, the unrealized losses would reduce banks’ propensity to extend credit—contributing to a tightening of financing conditions and slowing economic activity. In particular, the high-tech startups sector will experience growing funding difficulties in the foreseeable future. This sector is currently needed to sustain the US lead in its competition with China. The unrealized losses could also interact with deposit outflows to hobble segments of the banking system.
Fourthly, in the past year during which the Fed has raised rates, bank customers have moved about $500 billion of deposits from banks to money market mutual funds (MMMFs) offering higher yields. This shift is especially thanks to the fact that MMMFs can conduct reverse repo transactions with the Fed at 4.55 percent at no credit risk. Banks have had to compete by raising rates to attract deposits, including by issuing a growing volume of Certificates of Deposits. However, this has cut into their interest margins, reducing earnings going forward. More importantly, banks perceived to be weak would have suffered more deposit withdrawal. This “flight to quality” would accelerate now as clients scramble to diversify their deposits to stronger banks even with the recently announced measures—keeping segments of the banking system unstable.
Finally, most of the US banking system is not subject to the full force of the Dodd-Frank regulations. In 2018 President Trump signed into law deregulation legislation designed to exempt banks with assets less than $250 billion (the previous threshold was $50 billion) from the full application of the Dodd-Frank regulations—such as strict reporting requirements and stress tests. Consequently the full Dodd-Frank regulatory and supervisory regime only applies to the twelve largest US banks with assets more than $250 billion. The rest of the 4,706 strong banking system has been exempt. At present, it is not clear how rigorously most of the US banks have been supervised in the past few years, or how long it would take for supervisors to screen these banks to identify vulnerable ones and take precautionary measures. But the sooner they can do this, the better. More importantly, there should be an earnest debate to change the 2018 law to bring more banks back into the full Dodd-Frank regulatory and supervisory processes.
Besides interest rate risks which have crystalized into losses on bond portfolios, credit risks and losses threaten to move to the fore as the US economy slides toward recession. Of particular concerns are highly-leveraged loans packaged into collateralized loan obligations and commercial real estate loans—as identified in the Fed’s latest Financial Stability Report. These products have been distributed widely to banks and non-bank financial institutions such as pension funds, insurance companies, and investment funds. Similar to banks with weak funding bases, according to the Fed’s latest Monetary Policy Report, “prime and tax-exempt money market funds, as well as many bond and bank loan mutual funds continue to be susceptible to runs.” Consequently, these financial stability risks need to be dealt with as well.
In conclusion, even if the contagion effects of SVB, Silvergate Financial, and Signature Bank failures can be contained—still a big if—risks to the financial stability of the United States, and the world by extension, have increased significantly. The Fed no longer has the luxury to focus only on bringing down inflation. It must also avoid exacerbating financial stability risks. At the same time, the regulatory community should work with Congress to reform and strengthen the financial regulatory framework given the obvious weaknesses revealed over the past week. The current social and political polarization will undoubtedly make this exercise difficult—but it needs to be done.
Hung Tran is a nonresident senior fellow at the Atlantic Council; a former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.
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