There was no rest for the weary Wednesday, as regional bank shares in the US continued to look unstable a day on from a harrowing rout+.
The ongoing tumult raised the stakes for Jerome Powell, who, to quote Ricky Ricardo, “had a lot of explainin’ to do” following May’s FOMC meeting.
There’s a long list of legitimate questions that might fairly be asked of the Fed in the context of recent bank drama. Michael Barr tried to answer a lot of those questions last week with an internal review of the Fed’s supervisory failures around SVB. But the whole episode (which, Jamie Dimon’s “this is over” remarks notwithstanding, is ongoing) highlights the extent to which periods of extreme monetary largesse are conducive to the build up of risks that hide in plain sight, waiting on a tightening cycle to push them to the fore.
Paradoxically, the repetitious “this is nothing like 2008” assurances emanating from America’s top bankers (and, I’m sure, some policymakers, although I can’t recall a specific instance of a Fed official saying exactly that recently), are starting to feel a bit like “subprime is contained” and “inflation is transitory.” The more times an assurance gets repeated in the face of evidence to the contrary, the higher the meme risk, if you will.
The “it’s not 2008” banter is a red herring anyway. Bank crises and financial panics share certain characteristics, but they’re not all the same. Nobody serious has suggested America’s largest banks are in any kind of peril in 2023. In fact, it’s the opposite: If anything, they’re poised to get bigger and control more deposits as concerns around small and midsize lenders proliferate. That’s not to say the SIFIs are “happy” about the situation, it’s just to state the obvious.
Speaking of things that are obvious, the government needs to raise the deposit insurance cap, or guarantee business deposits or plead with Congress to make what’s already implicit, explicit. The FDIC effectively said as much this week. “Trends in uninsured deposits have increased the exposure of the banking system to bank runs,” a report dated May 1 said. Uninsured deposits accounted for nearly half of banking system deposits at the highs in 2021, the highest in three quarters of a century. Although uninsured deposits are held “in a small share of accounts,” the FDIC cautioned that they “can be a large proportion of banks’ funding.”
A new NBER paper called “Banking On Uninsured Deposits” underscored the risks. “The crucial element is the runnability of a deposit franchise built on uninsured deposits,” NYU’s Philipp Schnabl, Alexi Savov, Olivier Wang and Wharton’s Itamar Drechsler wrote. “Runs are absent at low interest rates because the deposit franchise brings little value to the bank, but appear when interest rates rise because the deposit franchise comes to dominate the value.”
So, liquidity risk rises with rates. As you might’ve noticed, rates rose very rapidly in 2022. Arguably, they wouldn’t have needed to rise so fast, and perhaps not even so far, had they not been cut as much in the first place (facilitating inflation), and had hikes commenced sooner than they did (which might’ve ameliorated inflation).
The situation at banks is a modicum of stable as long as deposit betas are low. In a separate study, the same authors noted that the value of US banks’ deposit franchises probably rose enough recently to offset the unrealized losses on loans and securities, but there are two problems: Deposit betas can rise and, crucially, “the cash flows on deposit franchise[s] depend on the behavior of depositors.”
Self-evidently, a severe enough run can “eliminate” the deposit franchise, in which case “the net loss to equity is the full unrealized loss on loans and securities.” As of February, that unrealized loss was $1.75 trillion, according to the authors’ “back-of-the-envelope valuation,” a figure they gently noted is “large compared to the equity capital of $2.2 trillion.”
In the first paper mentioned above, Schnabl, Savov, Wang and Drechsler noted that unlike rate risk, credit losses on banks’ investments can’t be preemptively hedged with options, and should they materialize, “can trigger a run” on uninsured deposits. Of course, the risk of credit losses also rises with rates, which is exactly why you’re hearing so much lately about CRE. CRE exposures at small and midsize lenders are significant, to put it politely.
In the May 1 report, the FDIC warned that social media is a factor. “The speed with which information, or misinformation, is disseminated and the speed with which depositors can withdraw funds in response to information may contribute to faster, and more costly, bank runs,” the report warned, adding that the same factors “may make it more challenging to promptly intervene.”
The Fed has surely thought a lot about all of this, as has Treasury, but markets are probably going to keep pushing the envelope. Traders and speculators smell blood. In the simplest terms possible, the risks are still there, and the underlying problems haven’t been addressed. So, there’s no reason enterprising traders wouldn’t try to fell the shakiest institutions. Unless you think altruism and a sense of civic responsibility is going to win the day.
After the bell, reports that PacWest is weighing strategic options, including a possible sale, sent the shares tumbling another ~50%.
I have no horse in this race (no deposits above any insurable amount), but it seems to me a simple enough problem. Gubmint insures the deposits in a bank for any amount, in return for bank agreeing to proper and appropriate regulation and oversight, enough so that the gubmint is unlikely to be on the hook ever. You (Mr. Bank CEO) want to be less regulated? Fine, but we won’t insure your deposits above the current $250k. Raising insured amount does solve the banking house of cards issue altogether, but it seems like it would help address one issue that can lead to the runs.
“doesn’t solve”, not “does solve”, in the last sentence.
Or put all checking accounts at the Fed and have the Fed pay banks a small fee to administer them. When people go to the bank to open their Fed checking account, the bank can then sell customers on savings products, term deposits and so on.
I don’t think the bank business model would survive moving demand deposits from banks to the Fed.
Not sure the current bank business model is going to survive. Period.
Interesting idea.
Perhaps something like this will occur by the natural process of banking being concentrated into progressively smaller number of progressively larger banks. Extended to asymptote, you have one very large bank, backed by the Fed as too large to fail, which produces a synthetic version of your proposal.
If anyone is interested in banks’ use (non-use) of hedging,
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4410201
Banks are disincentivized to hedge HFM because the hedging G/L hits earnings.
Banks don’t much hedge AFS either.
The paper doesn’t seriously examine why banks make these decisions; in my opinion, attributing it to “gambling” is facile.
My guess is that the cost of hedging has something to do with it.
As far as I’m concerned, at this time Social Media is the X-factor, and I sure hope the Biden administration, Treasury, and Fed don’t underestimate the threat and get caught flat footed…again…
Can the FDIC run out money and fail?
The FDIC levies banks generally to fund deposit insurance payouts on failed banks, and can/does impose heavier levies on large banks. That’s not an infinite pot of money, but I’d think the biggest banks can pay enough to cover quite a number of small bank deposit payouts. It’ll hit their earnings and capital, though.
Even in a messy bank failure, only a portion of deposits will require FDIC payouts, and eventually the bank’s assets will be sold off to recoup much of the payout.
The FDIC can also borrow from the Fed, and that pot of money is deep indeed.
I guess it would be better to have some actual calculations, which I don’t, but the FDIC running out of money seems pretty far down the list of things to fear.
The FDIC sounds similar to the US Pension Benefit Guarantee Corp (PBGC). It is funded in a similar fashion. The Congress has been forced to “shore it up” more than once.
One reason was that the much-esteemed corporate raiders who bought steel companies and other old-line companies with large legacy pension liabilities. They just put the companies into bankruptcy and dumped the pension obligations on the PBGC which eventually were passed along to the taxpayer. Mmmm… that sounds familiar doesn’t it? Private profits, socialized losses.
A possible distinction is that those pension plans were broadly underfunded, i.e. insolvent as stand-alone entities, and relied on income stream from the companies.
Banks are solvent, at least the great majority are. Even small and weak PACW is nominally solvent (assets less PPE and intangibles, minus liabilities, is slightly positive), which means after haircuts it is only modestly insolvent.