No Mystery in Bank Failures and No Reason For Fear

On Mar 25, 2023

The Senate Banking and House Financial Services committees are set to begin hearings next week on the failure of Silicon Valley Bank and Signature Bank. At the same time, the Federal Reserve Bank is launching its own probe. However, it may not have to look far for answers.

Following a quarter-point hike in the prime lending rate this week, Chairman Jerome Powell announced that Michael Barr, the Fed’s chief regulatory officer, will lead the review.

The Bank Failure Question

“The question we were all asking ourselves over the first weekend was, ‘How did this happen?’” Powell said at a Wednesday news conference.

Carl D. White, III, senior vice president of the St. Louis Fed’s supervision, credit, and learning division, answered at least part of the question before it was asked. White noted concerns about interest rate risks in a February 9 blog. That was almost a month ahead of Silicon Valley Bank closing on March 10.

White noted that the rise in interest rates that began last year is a double-edged sword for banks. Rate hikes have allowed banks to increase income by raising rates on loans. However, “they also could increase the cost of liabilities and decrease the value of investment securities held as assets,” he wrote.

“When you’re buying 30-year Treasury Bonds at two percent and the interest rate goes up to four percent in a short period of time, you’re going to lose money,” Gregory Germaine, professor of law at Syracuse University told SavingAdvice. Germaine specializes in bankruptcy, corporate, and commercial law.

Bank Deposits Up Loans Down

Most banks saw a large increase in deposits during the pandemic. In 2020, for instance, deposits rose over 20 percent, according to Federal Financial Institutions Examination Council research cited by White. With that cash and little or no loan generation, many banks invested more money in fixed-rate bonds.

The problem with committing to fixed-rate bonds for the long term is, as both White and Germine noted, the risk of interest rates rising. When interest rates rise, the value of bonds declines. For banks holding fixed-rate bonds – that results in unrealized or paper losses.

There is an old saying in investing that, “a loss is not a loss until you take it”. In the current banking situation, that means that portfolios of low-interest fixed-rate bonds stay hidden in the bank’s books. That is unless the bank is forced to sell them.

That is what happened with Silicon Valley Bank.

“For many banks, these unrealized losses will stay on paper,” wrote White. “But others may face actual losses if they have to sell securities for liquidity or other reasons.”

In addition to unrealized losses from fixed-rate bonds, banks are also loaded down with low-interest loans.

“There is estimated to be something like $1.7 trillion in unrealized losses from Treaturies,” said Germaine. “But that’s only part of it. Just think of all those home loans that were made at three percent. Nobody knows exactly how many loans like that are out there.”

Not to Worry

Trillions of dollars in paper losses seem like a lot of paper. However, Germaine is not frightened and says you should not be either.

“I see all these people on YouTube talking about unrealized losses and financial armageddon,” said Germaine. “That’s ridiculous. The truth is, banks make so much on deposits, they are going to earn their way out of this.”

Referring to the film “It’s a Wonderful Life”, Germaine said, “the movie got it right. The real risk in this is a run. There is no reason to pull money out of an account that is insured.”

That is what happened to Signature Bank.

Most banks carry Federal Deposit Insurance Corporation(FDIC) coverage that guarantees people with accounts up to $250,000 will have their money paid back to them in the event of any loss.

Bigger Many Not Be Better

The current banking turmoil poses another risk. If depositors dump regional banks in favor of a few big firms, options and opportunities will diminish, according to Germaine.

“I’m not seeing any risk to banking,” said Germaine. “I don’t see any more failures. There might be some mergers, but no failures. I do see a problem with people pulling money out of small regional banks and moving it to big banks.”

The danger in depositors fleeing to a few big banks is that it takes money away from local economies and reduces services to depositors.

“The premise of Capitalism is that a lot of players compete for your business by providing better services and products,” said Germaine. “Regional banks offer a lot of services and opportunities that big banks don’t. We need regional banks and we need a lot of them.”

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