Vanessa Pham always has plenty to worry about as chief executive of Omsom, a fast-growing Asian food kit company. But the possibility of losing all her start-up’s money in a bank run was not one of them — until now.
On March 9, she found herself scrambling to withdraw Omsom’s cash from Silicon Valley Bank. Pham was at a big food convention in Los Angeles when she started receiving alarming messages from her investors. The day before, SVB revealed it had sold a bond portfolio at a $1.8bn loss and was looking to raise $2.25bn in new equity to shore up its balance sheet. All of Omsom’s money was in an SVB account that by the end of the day she could no longer access.
Pham was just one of thousands of Americans caught up in the financial panic of the past month. The rapid increase in interest rates exposed cracks in how some banks have managed their balance sheets. Three lenders have collapsed, a fourth is still on the ropes. Billions have been wiped off the market valuation of banking stocks.
The crisis has big implications for US regional banks and their investors. Perceptions of risk have shifted sharply. Tougher regulation and lower profitability seem inevitable. Beyond this, US interest rate policy may now follow a gentler, slower trajectory.
Such considerations were a million miles from Pham’s thoughts as backers urged her to get Omsom’s funds out of SVB. But it was too late. Quicker customers had initiated withdrawals for $42bn that day, leaving the bank with a negative cash balance of $958mn.
The next day, regulators stepped in and seized control of SVB. It had taken less than 40 hours for a top 20 bank with $209bn in total assets to become the second-largest bank failure in American history after Washington Mutual in 2008.
“I never thought my money would be unsafe in a bank in the US,” Pham recalls.
Millions of Americans have had the same wake-up call and are taking a hard look at where they keep their cash. Two days after SVB’s collapse, New York-based Signature Bank folded after a similar depositor run. First Republic Bank received an industry-led emergency cash injection and has hired Lazard and JPMorgan Chase to advise it on strategic options. Pacific Western Bank had to turn to investment firm Atlas SP Partner for a $1.4bn financing facility.
Policymakers have taken extraordinary actions to quell panic among depositors. Nonetheless, deposits at small banks dropped by $120bn, or about 2.2 per cent, in the week to March 15, according to data from the Federal Reserve. Separate data shows that nearly $240bn has flooded into money market funds in the two weeks to March 22. Whether this deposit flight abates or continues will play a big role in determining the health of the country’s smaller banks and the businesses they serve.
The screen
The US Federal Deposit Insurance Corporation covers more than 4,200 commercial banks, or one lender per 80,000 citizens. By comparison, the UK only has 260 banks, or one bank for every 257,000 people. In the US, banks run the gamut — from top-tier Wall Street names such as JPMorgan to regional powerhouses such as PNC and community banks with less than $100mn in assets. Smaller lenders often service local areas and niche industries underserved by larger banks.
Financial panics are unpredictable, transmitted by word of mouth and its modern equivalent, social media. But the deposit flight has not been entirely arbitrary. It has singled out lenders with two characteristics. First, a high level of uninsured deposits, which in this context means more than $250,000 per depositor. Second, a large gap between the fair-market value and balance-sheet value of its assets. SVB was an outlier in both respects.
Lex has screened more than 150 US banks to build a picture of the sector’s health. Like any other ranking, it is just a snapshot of financial metrics and there is no reason to think that any of the smaller lenders on the resulting list that are trading normally will suffer an SVB-style collapse.
Financial panics are collectively irrational and may focus on characteristics not susceptible to screening. An example would be the highly networked nature of SVB’s client base in the west coast tech industry.
Still, our screen found that highly rated banks typically had low levels of so-called hold-to-maturity securities, which can generate heavy losses if they have to be sold in an emergency, and low exposure to commercial real estate.
The strongest regional banks in our screen were City National Bank of West Virginia, listed as City Holding Company, and FirstBank, which is quoted as First BanCorp and operates in the Caribbean and Florida.
Poorly-rated banks inevitably had lower capital relative to their lending and a lower ratio of liquid assets to deposits. The weakest players our screen identified were Wisconsin’s Associated Bank, listed as Associated Banc-Corp, and Valley National of New Jersey.
We rated banks for three broad characteristics: asset resilience, deposit liquidity and investor sentiment. Each of these buckets contained three measures. These included leverage ratio, liquid assets as a share of deposits and price to tangible book value respectively.
We restricted our screening of S&P Capital IQ Pro data to listed banks with market capitalisations of more than $1bn to exclude tiny lenders. We also left out large investment banks, brokerages and banks with missing data. That left us with 107 institutions comprising $14.6tn of assets of the US banking industry.
We have not adjusted rankings for the size of institutions above the $1bn market worth threshold. That meant industry behemoth JPMorgan came in a companionable joint 21st with FB Financial of Nashville. US mega banks are unimpeachably safe or simply too big to fail, depending on your viewpoint. They are included largely for comparative purposes.
Future tense
Fed actions to provide liquidity buffers to banks should help prevent further bank failures. In the meantime, depositor behaviour has changed. Banks will have to offer higher interest rates to keep nervous customers from defecting to rivals or putting their cash into money market funds. That means funding costs will rise, particularly for smaller and midsized banks, and earnings will be squeezed.
“Profitability issues will apply to the whole banking sector, albeit in different magnitudes,” says Eric Compton, an equities strategist for Morningstar Research. “Big banks like Truist should see less funding outflow pressure and are likely to be receivers.” But others like First Republic risk becoming so-called zombie banks unless they restructure their balance sheet or draw back deposit flows.
Another worry: tougher capital rules for midsize banks, currently under consideration from regulators, could further limit the industry’s ability to extend credit to businesses. While the 25 biggest banks account for over 63 per cent of the industry’s total assets, smaller banks account for 70 per cent of commercial real estate loans and 95 per cent of loans secured by farmland.
Tighter lending conditions could create a negative feedback loop that leads to a recession and more defaults. Commercial real estate, already reeling from falling occupancy post-pandemic, is increasingly seen as the next pressure point on banks’ balance sheets.
“The liquidity crisis will pass,” says Thomas Simons, a money market economist at Jefferies. “But a credit crisis is coming.”
Nothing is really risk free
Banks were flooded with nearly $5tn of new deposits during the pandemic. Armed with cheap cash, many loaded up on long-dated Treasuries or mortgage-backed securities that are guaranteed by the US government. These offered relatively attractive returns when rates were low. American banks held $5.5tn of such securities on their balance sheets at the end of 2022 — a 44 per cent increase compared to before the pandemic.
But the prices of these bonds fell when the Fed began to raise interest rates aggressively last year. Unrealised losses totalled $620bn at the end of 2022, according to the FDIC.
Such paper losses only crystallise when a bank is forced to sell these bonds and until they do, accounting rules allow them to soften the blow to capital adequacy. Security holdings can be classified as “held-to-maturity” or “available-for-sale”. Any losses in the AFS basket have to be marked to market and deducted from the bank’s capital base, but those in the HTM basket are excluded. To keep capital ratio stable, many banks have shifted assets away from AFS towards HTM.
Proponents say HTM accounting helps banks limit volatility in their equity and capital ratios. That can make sense — as long as depositors don’t ask for their money back and banks can hold the bonds to maturity. Otherwise, HTM accounting can give a false sense of capital cushion.
That was the case at SVB, whose $15.1bn of HTM losses were only just covered by $16bn of equity at the end of last year. Its poor risk management was compounded by a concentrated client base dominated by venture capital and tech start-ups. Some 94 per cent of SVB’s deposits were uninsured and hence more likely to flee at the first sign of trouble, the most of any bank with more than $50bn in assets. As interest rates rose, venture capital began drying up, forcing early-stage companies to draw down funds held on deposit at SVB to meet payrolls and other day-to-day expenses. Once SVB could not meet those withdrawals, it had to start selling off its securities portfolio at a loss.
“SVB woke people up to duration risk,” says Nathan Stovall, head of financial institutions research at S&P Global Market Intelligence.
A bank run for the digital age
The run on SVB was exacerbated by herd mentality and technology. Fear and panic can quickly spread via social media or WhatsApp groups. Rather than forming lines outside banks, depositors can pull out funds with a few taps on their banking apps.
Systemic risk just based on size of the institution is in need of a rethink, according to Michael Held, partner at WilmerHale and previously general counsel at the New York Fed. “Clearly here it wasn’t size, it was herd behaviour, cascading run risk,” Held says.
This raises a thornier question: can behavioural psychology be stress tested? Having taken deposit stability for granted during the years of low interest rates, the market now has to figure out how to model the likelihood of a bank run. No one perfect metric exists for this. But core deposits — money placed by smaller depositors who typically live within the bank’s market area — is one proxy.
These are usually seen as less prone to switching than large accounts, which often move among banks as interest rates change. For this reason, the Lex screen uses another metric — the level of time deposits that have a fixed period before they can be withdrawn by customers.
The other valuation gap
First Republic’s HTM losses were nowhere as high as SVB’s. It reported a paper loss of about $4.8bn against $17bn of shareholders equity at the end of last year. Instead, it is the valuation gap in its loan book that has attracted attention.
For years, First Republic lured high net worth customers with cut price rates on mortgages and loans. A loan-to-deposit ratio of 94 per cent suggests the San Francisco-based bank is using nearly all its deposits to fund its lending activities. It had $102bn worth of residential real estate loans on its books at the end of last year, almost all of which mature in 15 years or later.
Higher yields on ultra-safe Treasuries have made these long-dated, jumbo home mortgages look less attractive. The $19.3bn gap between the fair value of its real estate secured mortgages and their balance sheet value suggests as much. At the same time, the deposits of its wealthy customers are often too big to be insured by FDIC — meaning they are less sticky in times of stress. Unsurprisingly, First Republic’s stock price is a fifth of its tangible book value per share.
Where were the regulators?
Could recent events have been prevented? Even as the Federal Reserve has tightened its oversight of big Wall Street banks in the wake of the 2008 financial crisis, the reverse has been happening for smaller institutions. The 2018 rollback of the Dodd-Frank act, the biggest deregulatory effort since the 2007-08 financial crisis, raised the threshold for financial institutions to be considered systemically important to $250bn in assets from $50bn.
This mean banks with assets of up to $250bn were exempted from the Fed’s toughest supervisory measures, including stress tests as well as capital and liquidity requirements.
“I think if we didn’t roll back Dodd-Frank in 2018, it would have been less likely that SVB’s problems went unnoticed,” says Saule Omarova, a professor of law at Cornell University who was also once President Joe Biden’s nominee to serve as a top banking regulator. “SVB would have been subjected to additional requirements — like liquidity coverage ratio and net stable funding ratio — which is also important as a procedural matter. If you have to undergo stress tests several times a year, you would need to establish better internal controls. You would have an incentive to rebalance your portfolio more nimbly.”
The banks screened by Lex on average hold liquid assets equal to about a quarter of deposits. This is a simpler measure of liquidity than LCR, which measures liquidity relative to short-term obligations. JPMorgan is near the top of our ranking at almost three-quarters. Second from bottom, First Republic held liquid assets equal to just 4 per cent of deposits.
Profits: lower for longer?
A barrage of government actions — including the creation of a new emergency lending facility — are helping quell short-term liquidity worries by giving banks access to ample funding to pay out to depositors.
But these funds do not come cheap. The Fed’s Bank Term Funding Program — where banks can pledge their security holdings as collateral for loans — charges the one-year overnight index swap rate (currently at about 4.68 per cent) plus 10 basis points, for the use of the facility. Loans from the Federal Home Loan Bank system, regarded as the lender of second-to-last resort, charges similarly elevated market rates.
Depending on how long banks have to borrow at these rates and how much they earn from the assets on their books, net interest income will come under pressure. As a result, the Fed may opt to raise rates more slowly with the aim of reducing further shocks to the financial system.
Ultimately, banks will need to win back deposits, which are the cheapest form of funding. This is no easy task given the higher rates available elsewhere and shaken confidence in US banks.
Pham, as chief executive of a start-up, is illustrative of this shift. She eventually regained access to her company’s funds held at SVB. But she now splits the cash between three different banks and is looking into using different types of accounts — including those that would sweep her cash into money market funds.
“Watching a trusted system fail us has made me more thoughtful about where we store our funds,” she says.
Data visualisation by Chris Campbell
