Bank Failures Explained

First Republic joined Silicon Valley Bank and Signature Bank on the list of 2023 bank failures. JPMorgan Chase now owns most of its assets, and its customers are able to access funds even above the FDIC insured level of $250,000. But a lot of folks are worried about what could come next for banks and the economy.

Don’t Worry, Unless You’re a Banker

We don’t see signs to worry about the general economy or the financial system. Economic data remains healthy, credit markets don’t show signs of stress and the bond market is not predicting Fed rate cuts to fight economic troubles. And the Fed has shown a willingness to take action to protect even very large depositors above the FDIC insured amounts. We don’t see problems in the general real estate market exposing the entire financial system to risk, like 2008. But for regional banks is there reason to worry? The short answer is yes.

We would point to four reasons why regional banks are facing challengers.

#1 Some Bad Downtown Office Bets

As mentioned in our last post most of the commercial real estate market may look healthy and even some downtown markets, like Miami are doing well. But there are real problems with a few downtown office markets, like San Francisco, Seattle and Chicago. There is a good chance that some of those property owners will press for loan restructurings by threatening to walk away from the property and loan. Any regional banks overexposed with loans to underperforming downtowns will likely have their balance sheets further impaired.

#2 Bigger is Safer

A bigger problem for regional banks is that many bank customers, including businesses with large accounts, are deciding the smart thing to do is put their money with one of the too big to fail banks. Even smaller depositors within the FDIC insured amounts, don’t want to deal with the hassle of a possible Fed takeover. The government might let banks the size of First Republic fail, but it seems extremely unlikely a bank the size of JPMorgan Chase would be allowed to fail, due to the danger to the financial systems and economy. There is a good chance the trend of the too big to fail banks getting even bigger will continue.

#3 Rates & Duration Risk

This isn’t the only reason deposits have been leaving regional banks. Some investors are looking to move funds into brokerage accounts and invest in money market funds or other types of short-term high-grade debt instruments, including secure government debt, providing higher interest rates than their savings account. This problem is greatest for banks like Silicon Valley Bank that mismanaged their duration risk. Banks holding too many unhedged, long-term Treasuries at low interest rates at losses when marked to market, contributes to not being able to offer competitive interest rates, as well as their solvency being at risk when depositors leave.

#4 Free Money Bad for Business

Lastly, the Federal Reserve keeping interest rates so low for so long, really hurt the business model of banks. This distorted the commercial loan market. Regional banks particularly are hurting from not being able to make a reliable business from the spread of loaning money at a reasonable cost to companies financing productive activities with debt. Instead the Federal Reserve set the Fed Funds Rate (borrowing rate for banks) at close to zero before hiking it last year, induced risk taking and now the winners are the mega banks operating with an essential government guarantee against risk.

Long-Term Concerns

We may not see reasons to worry about a near-term economic crisis. But that does not mean we don’t have long-term concerns. We are not big fans of a few mega banks in partnership with the federal government becoming even bigger. In our opinion there are legitimate reasons for concern. We think bank customers are likely worse off. We worry about the political ramifications of this kind of concentrated power on citizens. It’s also likely that concentrating financing in fewer institutions, operating with implicit government guarantees, will be a negative for future economic growth. This will make it less likely, rather than more likely, capital gets allocated to the most productive uses. So, even though we don’t see reason to panic short-term, we do see reason to worry about the long-term ramifications.