In March, the US suffered a series of bank collapses. Two relatively large banks, Silicon Valley Bank and Signature Bank, collapsed in the space of a week, prompting fears of a 2008 style financial crisis. However, a month or so later, it looked like a crisis had been averted. The Federal Reserve extended its deposit guarantee, which basically means that the Fed promised to give money to anyone who needed it, and everything seemed to calm down. However, in the past few weeks, it looks like America's banking crisis has restarted. Last week, First Republic Bank collapsed and shares in a whole load of smaller regional US banks are falling at a rapid rate. So in this article, we're going to look at what caused America's slow moving banking crisis in the first place. Why First Republic collapsed earlier this week and what might happen next. Hint no one knows for sure, but things don't look great.
The banking crisis was actually caused by the recent rise in interest rates. Central banks across the world, including the US, have been raising interest rates in an attempt to bring down inflation because in theory higher rates should reduce borrowing and therefore consumer demand ultimately bringing down prices. Now in a simple world where banks just lend money to creditworthy customers, higher interest rates should be good news for banks because it means they make more interest from lending money. However, banking is no longer as simple as it once was, which means that higher rates can have unforeseen impacts on banks with signature, for example, higher interest rates, reduced speculative pressure on crypto assets, bringing down the price of crypto assets that Signature was holding with SVB, Higher interest rates reduced the real value of its Treasury holdings, which meant that when its depositors asked for their money back, SVB didn't have enough cash to actually pay them.
Anyway when SVB and Signature went bankrupt, lots of people were worried that this could spread out into a proper 2008 style banking crisis. Essentially, the worry was that depositors would see what happened to SVB and signature and rushed to take their money out of the banking system. This would basically trigger a system wide bank run with everyone racing to get their money out of the system before the banks run out of cash. This would obviously be a catastrophe. Banks would have to stop lending to make sure they have as much cash on hand as possible, which would almost definitely trigger a recession. And even then, they probably wouldn't have enough cash to actually pay all their depositors. To avoid this, the Federal Reserve announced that they would be extending their deposit guarantee to cover deposits over $250,000. Here the Fed were basically trying to stem the bank runs by basically telling people that they didn't need to worry about taking their money out because the Fed would pay them back even if their bank went under. However, this guarantee only applied to certain larger banks, which put pressure on smaller banks as their customers desperately shifted their money to these better insured, larger banks. One of the worst affected was First Republic, which lost $100 billion, representing over 50% of all their deposits. First, Republic's collapse was temporarily averted when a consortium of private banks led by Jp morgan agreed to bail them out with a $30 billion cash injection. But this wasn't enough, and on Monday, the bank collapsed. Since then, a whole load of other smaller banks, mostly regional ones, have started showing signs of distress.
We're not going to go into specifics because well, unless you know a lot about regional banks, it's not that informative. But the headline here is that regional bank stocks have been falling fast as depositors raced to withdraw their money. So what's going on here? Why are all these mid-sized regional banks suffering? Well, there are some contributing factors. The Fed is slowly withdrawing support for certain bits of the credit market, which mostly affects banks, and further interest rate hikes look more likely than they did a few weeks ago. There's also the risk of debt ceiling induced US default, and regional banks are particularly exposed to US commercial real estate like office spaces, which is looking a bit shaky at the moment. But ultimately this looks like an old fashioned bank run. Depositors are worried and they're racing to get their money out. Now bank runs are always self-perpetuating because as more people withdraw cash, the likelihood of the bank running out of cash increases, triggering further withdrawals. But the feedback loop has been accelerated by two things. First, because most banking is now done online, it's easier than ever to withdraw your money, which makes bank runs that much faster. Second, the process is accelerated by short sellers who see the beginning of a bank run and then bet against the bank, which pushes down the value of its shares and makes a default more likely. So you get the idea, it's an old fashioned bank run, but in the modern world, Bank runs happen astonishingly fast, which makes them way harder to deal with.
So what happens next? Well, no one knows for sure. But as we see it, if things continue to go downhill, the Fed has basically two options and neither is great. Option one is to extend its deposit guarantee further to include basically all US banks. While this might stem the crisis, it's a de facto nationalization of the banking sector and it creates enormous moral hazard. In other words, if banks know that the Fed will cover them, if they go bust, they've got no incentive to be careful with their lending, which means they'll start taking crazy risks and lending to bad businesses, which would be bad for the economy. Alternatively, the Fed could impose stricter reserve requirements. In other words, banks would have to hold more cash in reserve to better protect against bank runs. While this might be a sensible reaction to the fact that bank runs now take hours instead of weeks, it's more of a long term solution, and it probably wouldn't solve the immediate crisis. This would also lead to an economic slowdown because more reserves means less lending from banks, which means less money and less growth. So all in all, things aren't looking great.