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How Long Can America’s Regional Banks Last?

WType of hat The story is unfolding in the banking system? At first glance, this seems like a tragedy. In the past two weeks, four banks have come to a dead end: two crypto lenders, Silicon Valley’s dominant bank, and most recently a global systemically important bank. There have been 11 hours of intervention to protect customers, the establishment of an emergency lending facility and a marriage between two competing giants.

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But look again, maybe it’s a sci-fi story. New York University finance professor Thomas Philippon (new), experiencing the vertigo of time travel. “It feels like we’re really back in the 1980s,” he said in a recent talk. During that decade, high inflation led to extreme monetary tightening, a measure that Fed Chairman Paul Volcker enthusiastically pursued. This undermines the health of “savings and loan” banks (Second&Lifts), consumer savings institutions, also known as “thrifts,” primarily offer long-term fixed-rate mortgages. They faced a cap on the interest rates they could pay on deposits, which led to the flight. They hold fixed-rate assets. When interest rates rose, those mortgages lost considerable value—essentially wiping out the savings industry’s net worth.

To anyone who follows Silicon Valley Bank, this dynamic will sound familiar (SVB), interest rate shocks slashed the value of their fixed-rate assets, prompting deposit flight and institutional collapse. The question now is whether what has happened in the past two weeks has been brutal austerity, or the start of a long, drawn-out process like the 1980s.The answer depends to what extent SVBThe problem was found elsewhere.

Start with the asset value of the financial institution. Banks regularly publish data on the losses they face on fixed-rate assets such as bond portfolios. If these assets had to be liquidated tomorrow, the industry would lose nearly a third of its capital base.Worryingly, 1 in 10 institutions appear to be undercapitalized SVB.

However, that’s a big “if”. As long as depositors hold on, such paper losses are hypothetical. A recent paper by Itamar Drechsler of the University of Pennsylvania and co-authors shows that bank deposits, which tend to be stable and insensitive to interest rates, are a natural hedge for long-term fixed-rate loans that banks borrow. grace. The paper argues that “banks are closely related to the interest rate sensitivity of their interest income and expenses”, which results in very stable net interest margins. This explains why bank shares do not crash every time interest rates rise, but fall like the broader market.

The most obvious evidence of the flight came from two California-based banks.First Republic has reportedly lost $70 billion in deposits — about 40% of its total by the end of 2022 — since SVB Failure. Many of the lenders’ clients are wealthy individuals who seem to be the quickest to withdraw their deposits. On March 17, the First Republic placed $30 billion worth of deposits in 11 major banks. It is now reportedly seeking additional support from financial institutions and governments. On March 21, another California bank, PacWest, reported that it had lost a fifth of its deposits since the start of 2023.

Banks suffering from deposit flight, such as First Republic and PacWest, can turn to other financial institutions for liquidity — or they can turn to the Fed’s newly expanded lending facility. U.S. banks borrowed $300 billion from various Fed programs in the week to March 15, official data showed. There are some indications that much of the borrowing is not done by failed banks — namely, SVB Signatures – done by West Coast banks, including First Republic and PacWest. In fact, about $233 billion of the total lending by the San Francisco Fed covers banks west of Colorado. On March 21, PacWest revealed that it had borrowed a total of $16 billion to date from various Fed loans to shore up its liquidity. At best, any one Fed bank backing the rest of the country has only about $2 billion in borrowing, suggesting banks in other states are not yet facing serious deposit flight.

Policymakers must now wait to see if more banks come forward. It will be an uncomfortable pause. Regional and community banks play an important role in the U.S. economy and undertake about half of all business loans in the country. Smaller banks in particular dominate the commercial real estate sector. They hold nearly 80 percent of all commercial mortgages offered by banks. The temptation, which U.S. officials have been vague about, is to ensure that smaller banks do not lose deposits by guaranteeing large deposits.

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This could make for a scary scene: a zombie horror movie.At least that’s the argument made by Viral Acharya, too new• Banks with unstable deposit bases and loss-making assets face real losses. According to Mr Acharya, the worst possible outcome could be “you leave the bank undercapitalized, but you say all depositors in the weak bank are safe”.

Such interventions have been common historically, he said, and “every time that happens — it happens in Japan, it happens in Europe, it happens often in China and India — you get zombie banks”. These are uncapitalized, backed by the government and “tend to generate a lot of non-performing loans”. He cites the undercapitalized Bank of Cyprus in 2012 as an example: “Even though Greece is actually collapsing, they’re still betting the whole house on Greek debt. Why are they doing that? Well, they have stable deposits and nobody’s giving them up, They have no assets left – and then shortly thereafter you have a spectacular bank failure.”

The thrift crisis in the US in the 1980s ended up being so costly because the initial response—when thrifts faced losses of about $25 billion—was one of patience. Many insolvent thrifts were allowed to stay in business in an effort to keep them out of losses. But their problems will only get worse. They are also called “zombies”. Like the Bank of Cyprus, these zombie firms went bankrupt by investing in increasingly risky projects in the hope that they would earn higher returns. By the time the returns do materialize, zombie firms are already insolvent. The eventual bailout cost taxpayers $125 billion, five times what it would have cost if regulators had bit the bullet earlier. It would be a real tragedy to have that zombie movie happen again.

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