With the failure of three regional banks since March, and another one teetering on the brink, will America soon see a cascade of bank failures?
Bloomberg reported Wednesday that San Francisco-based PacWest Bancorp is mulling a sale.
Last week, First Republic Bank became the third bank to collapse, the second-largest bank failure in U.S. history after Washington Mutual, which collapsed in 2008 amid the financial crisis.
After the demise of Silicon Valley Bank and Signature Bank in March, a study on the fragility of the U.S. banking system found that 186 more banks are at risk of failure even if only half of their uninsured depositors (uninsured depositors stand to lose a part of their deposits if the bank fails, potentially giving them incentives to run) decide to withdraw their funds.
Uninsured deposits are customer deposits greater than the $250,000 FDIC deposit insurance limit.
Regional banks are failing because the Federal Reserve’s aggressive interest rate hikes to tamp down inflation have eroded the value of bank assets such as government bonds and mortgage-backed securities.
Most bonds pay a fixed interest rate that becomes attractive when interest rates fall, driving up demand and the price of the bond. On the other hand, if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, thus driving down its price.
Many banks increased their holdings of bonds during the pandemic, when deposits were plentiful but loan demand and yields were weak. For many banks, these unrealized losses will stay on paper. But others may face actual losses if they have to sell securities for liquidity or other reasons, according to the Federal Reserve Bank of St. Louis.
“The recent declines in bank asset values very significantly increased the fragility of the U.S. banking system to uninsured depositor runs,” economists wrote in a recent paper published on the Social Science Research Network.
Of course, this scenario would play out only if the government did nothing.
“So, our calculations suggest these banks are certainly at a potential risk of a run, absent other government intervention or recapitalization,” the economists wrote.
How did Silicon Valley Bank collapse?
In the case of the Santa Clara-based Silicon Valley Bank, which held most of its assets in U.S. government bonds, the market value of its bonds fell when interest rates started going up.
That’s because most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand and the price of the bond. But when interest rates rise, the lower fixed interest rate paid by a bond is no longer attractive to investors.
The timing coincided with the financial difficulties many of the banks’ customers – largely tech startups – were dealing with, forcing them to withdraw their deposits.
In addition, Silicon Valley Bank had a disproportional share of uninsured funding, with only 1% of banks having higher uninsured leverage, the paper notes. “Combined, losses and uninsured leverage provide incentives for an SVB uninsured depositor run.”
A run on these banks could pose a risk to even insured depositors − those with $250,000 or less in the bank − as the FDIC’s deposit insurance fund starts incurring losses, the economists wrote.
By Swapna Venugopal Ramaswamy / USA TODAY