Understanding Recent Bank Failures

March 15, 2023

We would like to take a moment to provide some insight and perspective into the current problems in the banking industry.  

The Basics:

Banks work by borrowing money from depositors and then investing that money in loans, like mortgages and small business loans and buying treasury and other bonds. Banks make money by the “spread” - the difference between what they pay as interest to depositors and what they earn in interest from debtors. If the loan portfolio lends at 6% and they pay 3.5% to depositors, the 2.5% difference is revenue to the bank.

Their revenue decreased in the past year for two reasons. First, the spread between debtors and depositors has shrunk. Interest rates rose by over 4%, so depositors expected to receive more in interest than they were paid in the past. Most bank loans are at fixed rates; they don’t adjust every day, and many don’t adjust for a number of years. So, banks had to pay more to their depositors, but couldn’t increase the rates on many of their loans.

Second, the value of the loans and bonds the banks hold as assets, what they call their “loan portfolio”, lost value. But based on an accounting rule, they have not had to realize the losses on their balance sheets.

This is a little complicated, so let’s think about this like the bonds in your portfolio. Last year, interest rates rose. As they rose, new bonds and loans were issued with higher interest rates – think about mortgage rates over the past year. The value of a loan depends on its interest rate. In a $1,000 bond maturing next year, and paying 2%, at the end of the year, we will be paid $1,020. On a 5% bond, we would be paid $1,050. The 5% bond is worth more than the 2% one.  In fact, the 2% bond in that situation is no longer worth $1,000. Its value drops to $971. ($971 at 5% will become $1,020 at the end of the year.) As rates rise, new bonds are issued at a higher interest rate, and the old bonds, paying a lower interest rate lose value.  

Generally, investors saw this decline on the monthly statements in their investment accounts. The leading bond index, the S&P U.S. Aggregate Bond Index, lost 13.06% in 2022. As it fell, most investors saw those losses in real-time in their portfolios.  

Under the law, banks were not required to change the value of their loan portfolios. Between January and December 2022, the value of the bonds on the bank’s balance sheets remained constant even while the bond market fell by double digits. So, the real value of their portfolio is probably 10-15% less than their balance sheet shows.

When you add those two things together, it makes sense there is instability in the banking sector. They are generating less income and their assets lost value.

The Past Week:

This has been a classic bank run. Individuals and companies pulled their money out of Silicon Valley Bank (SVB) en masse. Over the weekend the FDIC took over the bank. In New York, regulators closed Signature Bank. Through yesterday afternoon, the stocks of First Republic Bank and PacWest Bank had lost over 60% of their value.

The Federal Reserve, Treasury Department and FDIC issued a statement on Sunday evening guaranteeing all depositors of SVB and Signature Bank the full value of their deposits and issued an additional $25 billion as a backstop to other banks which may need capital.

Though this is portrayed as “the second largest bank failure,” it is important to remember SVB is a medium-sized bank. It is less than 1/10th the size of either J.P. Morgan or Bank of America. Currently, bank problems seem to be most acute in institutions with concentrated depositors (a small number of large depositors) who have average deposits much larger than FDIC limits. In banks with smaller average depositors, the FDIC protection seems to be working to calm fears of contagion.

Next Week and Beyond:

There has been a zero-interest rate policy in the U.S. for the past few years, and a very low interest rate policy since the Great Recession. In situations like this, there is an incentive to take risks – even by banks. At the same time, depositors generally assume their money in the bank is safe, even if it is over the FDIC limit.

When something like this happens, we are often asked by clients “What should I do?” For anyone with less than $250,000 in the bank, there is no reason to make a change. If you have more than the FDIC limit in a single bank, and are concerned, give us a call. We would be happy to discuss your situation in more detail and provide some options for you. We may recommend opening another account for additional FDIC protection, but just as likely we’ll recommend staying put for the time being.

Banks, by definition, cannot be fully liquid. They are designed to work under rational circumstances. In a panic, if all depositors asked for their money at once, no bank would be able to handle that request. At the same time, with interest rates at close to zero for the past few years, it’s likely that other banks will.

In the Great Recession, the Federal Reserve and Treasury learned their lesson about bank failures. The government did not support Lehman Brothers, and the chaos that ensued almost took down the rest of the banking system. I would expect the Federal Reserve, Treasury and FDIC to continue to work together to avoid widespread panic and support our trust in banks.