The US banking system is looking increasingly vulnerable as interest rate rises put pressure on liquidity and capital reserves. Silicon Valley Bank and First Republic could indicate the start of a wider collapse – but how did the banks end up in this mess and why were precautions not put in place? Gill Wadsworth explores the impact these nerves are having on the market.
The American people are “probably as confused about banking as ever and that has consequences”, chief executive Warren Buffett warned shareholders at the Berkshire Hathaway AGM this May.
The veteran investor was addressing the possibility of a banking crisis in the US, after three institutions tumbled in quick succession in the spring of this year.
Federal government was forced to step in to shore up deposits at Silicon Valley Bank and Signature Bank, two of the casualties that fell on March 8 and 12 respectively, above the standard $250,000 limit covered by insurance.
But Buffett notes despite such intervention, “you can have a run [on banks] in a few seconds”.
The next domino to fall
There was a gap of less than two months before the next US bank imploded. On 1 May the Federal Deposit Insurance Corporations (FDIC) took control of First Republic resulting in a takeover by JP Morgan, and the loss of a rumoured 1,000 jobs.
James Rutherford, head of European equities at Federated Hermes, says that after JP Morgan’s intervention “the calm lasted all of a day” before concerns resurfaced about which “regional bank will be the next domino to fall”.
“There is a risk that we enter a self-fulfilling cycle of negative sentiment leading to lower stock prices, higher funding costs and deposit flight, which could result in mark-to-market losses on banks’ held-to-maturity assets,” Rutherford says.
Muhammed Demir, head of capital markets at multi-asset broker Swiss Finance Corporation, agrees that nervy investors make for a flight risk.
“The banking system is all built on confidence. It’s just like a relationship, when you lose the confidence, you’re going to have issues. It doesn’t matter whether those issues are real or not. When you lose the confidence, then you start to make things up in your mind.”
He continues: “The banking system is like that as well. If you put any question marks in the minds of the investors or depositors, then that can push us towards a world where we only go for the big [banks].”
Demir warns other regional banks look wobbly including East West Bank, Harris Bank and Comerica, which he says share one common denominator: the number of uninsured deposits which are “making clients nervous”.
And while regulators have managed to circumvent the limits on deposit insurance arguing that failure to do so would cause system risk, this is not a route they can take easily and there are concerns over the associated legal implications and legislative process.
Steven Bell, chief economist (EMEA) at Columbia Threadneedle Investments, says “Many of the powers the US authorities used so successfully in the global financial crisis in 2008, such as extending deposit insurance, have since been rescinded by Congress. And so far, buyers have been found for failing regional banks – but there are limits to that process.”
Antiquated infrastructure
The Dow Jones US Banks Index has returned -20.97% in the past year and was trading at 395.02 on 1 June versus 496.22 on the same date in 2022.
But such losses are not the result of the trio of regional banking failures, rather they have been driven by the increase in interest rates which subsequently pushed down the prices of government bonds.
David Dowsett, global head of investments at GAM Investments, says: “It is important to stress that this is not a bad asset problem. The global financial crisis was such a problem, where banks had significant assets on their balance sheets that were not worth anything or worth very little; this is not the case this time. We have a mark to market situation and level of uncertainty associated with government bonds and the bubble that burst last year which has to work its way through the system.”
Dowsett says there is no “silver bullet to resolve this issue”, and the sector will just have to let the situation play out.
He adds: “It is worth bearing in mind that government bonds will mature at par. From this perspective, there is less price risk than there has been in previous episodes of banking uncertainty.”
The decade of low interest rates gave banks, according to Peter Dehaan, head of business development for cash and liquidity management at SmartStream, considerable flexibility, but a return to 5.25% this year – with a likelihood they will go higher this summer – means institutions need to adopt a more disciplined approach.
“When interest rates were zero, you could be long, you could be short; it wasn’t really such a big deal. But now the rates have gone up and there’s been evidence of some mismanagement. Higher rates will only serve to exacerbate any problems with risk management,” he says.
Dehaan says many banks still run “antiquated and fractured infrastructure”, relying on databases and spreadsheets to run tens of thousands of transactions.
“These systems have had little or no investment over time. Banks need to build new infrastructure themselves, bolster what they have; or buy from a third-party vendor. As with any business, the ones that don’t [invest] stand a chance of going under.”
Reduction in risk tolerance
Commentators appear relatively optimistic that a full-blown banking crisis in the US will be avoided since, as Columbia Threadneedle’s Bell says, the mega banks have “suffered little in this latest crisis; indeed, they may even prosper in the longer term as they pick up rivals on the cheap”.
However there is evidence that banks are starting to curb their lending activity for fear of being the next casualty.
April’s Senior Loan Officer Opinion Survey, which gauges banks’ attitude to lending, found that for the remainder of 2023 respondents expected to tighten standards across all loan categories. Banks most frequently cited an expected deterioration in the credit quality of their loan portfolios and in customers’ collateral values, a reduction in risk tolerance, and concerns about bank funding costs, bank liquidity position, and deposit outflows as reasons for expecting to tighten lending standards over the rest of the year.
Bell says: “The fear among many US banks that they might be the next victim will cause them to be ultra-cautious in their lending. Indeed, a significant tightening had already occurred before the failure of Silicon Valley Bank.”
He adds: “[The mega banks] are unlikely to pick up all the slack in terms of credit supply left by their weaker brethren and will surely further tighten the terms of any loans they do make.”
The possibility of a credit crunch may be the last straw for the US which is already fighting off a looming recession, and commentators want to see more federal intervention if the banking sector is to avoid making more unhelpful contributions to the unstable economic conditions.
Demir concludes: “We need to make sure that we have proper regulations and policies in place to make people’s investments safe.”
©Markets Media Europe 2023
