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Wednesday, June 7, 2023

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How corrupt is the U.S. banking industry?

Secondankin is a Confidence trick. Financial history is littered with runs for the simple reason that no bank can survive if enough depositors want to be repaid at the same time. So the trick is to make sure customers never have a reason to walk away with their cash. It is the owner of Silicon Valley Bank (SVB), once the 16th largest bank in the US, underperformed at critical moments.

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the fall of SVB, a 40-year-old bank, was formed to cater to the Bay Area tech scene in less than 40 hours. On March 8, the bank said it would issue more than $2 billion in equity, partly to cover bond losses. That prompted a review of its balance sheet, which revealed about half of its assets are long-term bonds, many of which are underwater. In response, deposits worth $42 billion, a quarter of the bank’s total, were withdrawn. At noon on March 10, the regulator announced SVB Failed.

This may be a one-off. SVBHis business — banking services for techies — is unusual. Most customers are corporations holding more than the FDIC-protected $250,000 (FDIC), Regulator. If the bank fails, they will face losses.and SVB Use savings to buy long-term bonds during market peaks. Former Treasury Secretary Larry Summers said: “One might think that Silicon Valley Bank would have failed without contagion.” Still, withdrawal requests from other regional banks in subsequent days showed that “there was actually a lot of contagion.” “.

Hence the intervention of the authorities. Before the market reopened on March 13, the Federal Reserve and the Treasury Department revealed that New York-based Signature Bank was also closed. They announced two measures to prevent more crashes.First, all depositors SVB The signature will be complete and direct. Second, the Fed would create a new emergency lending facility, the Bank Term Funding Program. That would allow banks to deposit high-quality assets such as Treasuries or mortgage bonds backed by government agencies in exchange for cash advances equal to the asset’s face value rather than its market value.As a result, those banks holding bonds that have fallen in price will be protected SVBfate.

These events raise profound questions about the US banking system. Regulation after the financial crisis was supposed to inject capital into banks, increase their cash buffers and limit the risk they could take. The Fed is supposed to have the tools needed to ensure solvent institutions continue to operate. Crucially, it is the lender of last resort, able to swap cash for prime collateral at penalty rates within its “discount window”. Being a lender of last resort is one of the most important functions of any central bank.As Walter Bagehot’s former editor economistwrote in Lombard Street 150 years ago, that the job of central banks is to “provide, in panic, every present security, or every currency usually and usually lent.” That “may There is no way to save the bank; but if it doesn’t, nothing can save it.”

Intervention by the Fed and Treasury is the kind that is expected in a crisis. They have fundamentally reshaped America’s financial architecture. At first glance, however, the problem appears to be one bank’s mismanagement of risk. “Either this is an irrefutable overreaction, or the U.S. banking system is far more rotten than those of us who don’t have access to classified regulatory information can ever know,” said Peter Conti-Brown, a financial historian at the University of Pennsylvania. “Which one is that?”

To assess the likelihood, it is important to understand how changes in interest rates affect financial institutions. A bank’s balance sheet is a mirror image of its customers. It owes depositors money. The loans people owe it are its assets. In early 2022, when interest rates are close to zero, U.S. banks hold $24 trillion in assets. About $3.4 trillion of that was to repay depositors with cash on hand. About $6 trillion is invested in securities, primarily Treasury or mortgage-backed bonds. Another $11.2 trillion was spent on loans.U.S. banks fund these assets with a massive deposit base worth $19 trillion, about half of which is held by FDIC Half are not. To protect against asset losses, banks hold $2 trillion of the highest quality “primary equity.”

Then the rate jumped to 4.5%. SVBThe bank’s decline has drawn attention to the fact that rising interest rates have reduced the value of banks’ portfolios, a hit that hasn’t shown up on their balance sheets.this FDIC In total, US financial institutions had an unrealized market value loss of $620 billion, the report said. It is possible, as many have done, to compare these losses to the equity held by the banks and panic. Overall, the 10% hit to bond portfolios, if realized, would wipe out more than a quarter of bank equity. The financial system may have been well capitalized a year ago, hence the debate, but much of that capital has been taken away by higher interest rates.

This becomes even more worrisome when other assets adjust for higher interest rates, as USC’s Erica Jiang and coauthors do. For example, there is no real economic difference between a 10-year bond with a 2% coupon and a 10-year loan with a fixed rate of 2%. If the value of the bond falls by 15%, the value of the loan will also fall. Some assets will be floating rate loans, where the interest rate rises with market rates. Helpfully, the data the researchers compiled breaks down loans into fixed-rate and variable-rate loans. This allows the authors to analyze only fixed rate loans. result? The value of bank assets would be $2 trillion less than reported – enough to wipe out all equity in the US banking system. While it is possible to hedge some of this risk, it is costly to do so, and it is unlikely that banks will do much of it.

But as Ms. Jiang and her co-authors point out, there is a problem with stopping the analysis here: the value of the balance deposit base is also not being reassessed. And it’s more valuable than it was a year ago. Financial institutions generally do not pay any fees for deposits. These are also sticky because depositors keep their money in checking accounts for years. Meanwhile, the price of the 10-year zero-coupon bond has fallen nearly 20% since the start of 2022 amid rising interest rates. That means being able to borrow ten years’ worth at 0% is a very sticky, low-cost deposit base that’s actually 20% higher than last year — more than offsetting losses in bank assets.

Therefore, the real risk for banks depends on deposits and the behavior of depositors. When interest rates rise, customers may move cash into money market or high-yield savings accounts. This increases the cost of bank financing, although usually not by that much.Sometimes—if the bank is in serious trouble—deposits are wiped out overnight because SVB Discovered in devastating fashion. Banks with large, sticky, low-cost deposits need not worry much about the market value of their assets. In contrast, this is especially true for banks with illiquid deposits. As Oliver Wyman’s Huw van Steenis points out: “A paper loss becomes a real loss only when it materializes.”

How many banks hold large amounts of securities, or make large fixed-rate loans, and are uncomfortable with volatile deposits? Insured deposits are the stickiest because they are protected if something goes wrong. So Ms. Jiang and her coauthors looked at uninsured cash. They found that if half of those deposits were to be withdrawn, the remaining assets and equity of the 190 U.S. banks would not be sufficient to cover the remaining deposits. These banks currently hold $300 billion in insured deposits.

The newfound ability to exchange assets at face value at least makes it easier for banks to pay depositors under the bank’s term funding scheme. But even then, this is only a temporary solution. Because the Fed’s new tool is itself a confidence trick. The program props up struggling banks for as long as depositors think they can. The market rate for borrowing through the facility is about 4.5%. This means that if a bank earns less interest income on its assets than that — and its low-cost deposits leave — the institution is only slowly dying from quarterly net interest income losses, not quarterly The loss of net interest income and the rapid death of a bank run.

That’s why Larry Fink, boss of big asset manager BlackRock, has warned of a “slow development crisis”. He expects this will involve “more seizures and closures”.High interest rates expose asset-liability mismatches SVB This, he argues, is “the price we pay for decades of easy money”. Mr Conti-Brown of the University of Pennsylvania points out that there are historical parallels, most notably in the 1980s when then-Fed Chairman Paul Volcker’s interest rate hikes took a toll on the banking sector.

Higher rates are the first to expose problems in bond portfolios, as the market shows in real time how those assets lose value as rates rise. But bonds are not the only assets that take on risk when policy changes. “The distinction between interest rate risk and credit risk can be very subtle,” Mr Conti-Brown noted, because rising interest rates can also end up stressing borrowers. In the 1980s, the first banks to fail were those whose asset values ​​fell as interest rates rose — but the crisis eventually exposed bad assets in America’s “throttle institutions” (specialty consumer banks) as well. So pessimists fear that banks now failing because of higher interest rates is just the first domino to fall.

The upshot of all of this is that the banking system is far more fragile than regulators, investors and, presumably, the bankers themselves believed just over the past week. It is clear that smaller banks with uninsured deposits will need to raise more capital soon.Torsten Slok of private equity firm Apollo points out that a third of the assets in the U.S. banking system consist of assets smaller than SVB. All of these will now tighten lending in an attempt to strengthen their balance sheets.

Mid-sized banks may be too big to fail: lesson regulators should learn SVBThe event also upended other fables of post-crisis finance. “After 2008, investors thought deposits were safe and market funding was risky. They also thought Treasuries were safe and loans were risky,” said Angel Ubide of hedge fund Citadel. “All post-crisis rulebooks were written on this basis. Now it seems like the opposite is happening.” One fable, however, remains intact. Problems with the financial system never emerge from the place of greatest concern.

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