US regional banks, the weakest link a year after the fall of Silicon Valley Bank

When, as Secretary of the Treasury, Steven Mnuchin went with his wife to the issuance of the first banknotes that bore his signature, there was many jokes and memes about how they looked like movie villains. This week, Mnuchin has become the hero, at least temporarily, who has come to the aid of New York Community Bancorp (NYCB), which is fighting for its survival in the face of a torrent of bad news. NYCB illustrates the extent to which US regional banks remain under pressure a year after the collapse of Silicon Valley Bank (SVB). It is also the best example of how concerns have shifted from interest rate risk and liquidity to commercial real estate credit exposure.

A report published this week by the International Monetary Fund (IMF) notes that the group of weak US banks represents an estimated total of 5.5 trillion dollars in assets, almost 23% of total bank assets. “Underlying concerns remain, with fears that the failure of one entity could precipitate a broader loss of confidence in the sector,” he says.

The latent losses due to the rise in rates (which have devalued the banks' bond portfolio) are combined with the credit risk of some entities, particularly their exposure to commercial real estate credit (CRE). Small and regional banks are highly exposed, with about two-thirds of the $3 trillion of risk in that sector of the U.S. banking system, according to the IMF.

“The high concentration of CRE exposures represents a serious risk for small and large banks in an environment of economic uncertainty and higher interest rates, potentially declining real estate values ​​and deteriorating asset quality,” the report states.

For now, NYCB's crisis appears contained. Not only because the entity has found a lifeline, but because the contagion has been lower. However, given the interconnectedness of the financial system, even the bankruptcy of a non-systemic entity can threaten financial stability. That is what the fall of SVB demonstrated, the second largest bank failure in the history of the United States, which was followed, days later, by Signature Bank (the third) and weeks later by First Republic Bank, all They were bailed out by the Federal Deposit Insurance Corporation (FDIC), which is then passing the bill to the banks.

The banking crisis of a year ago can be explained as a butterfly effect—or coronavirus effect—of the pandemic. With the covid crisis, the federal government gave generous aid with which deposits skyrocketed. Some banks invested these resources in long-term bonds. The liquidity fueled inflation and that led the Federal Reserve to raise rates. With the rate increases, capital losses appeared in bond portfolios, while deposits were reduced (particularly in venture capital and new technology companies, SVB clients). The clamp squeezed on both sides: the passive (deposits) and the active (bonds). A virus spreads in Wuhan and three banks fail in the United States three years later.

A disastrous recommendation

The fall of Silicon Valley Bank, however, was also due to other factors. The Silicon Valley Bank ship had a leak, but perhaps could have reached port to repair the leak if not for a storm of factors. Everything that could go wrong, went wrong. The former CEO of SVB, Gregory Becker, explained in the Senate that his bank, like many others, had losses in its debt portfolio, but that he allowed himself to be advised by Goldman Sachs to sell it and increase capital in what ended up being a disastrous recommendation.

“On the advice of Goldman Sachs, we decided to sell our available-for-sale portfolio in order to realize those losses and explain to the market why we were raising capital, given that SVB's finances were otherwise healthy. SVB had sufficient liquidity and was adequately capitalized on March 8 [el día en que puso en marcha esa operación por consejo de Goldman Sachs]as their Federal Reserve supervisory teams had previously recognized,” Becker said.

On March 8, the day the operation was announced, Silvergate Bank, focused almost 100% on cryptocurrencies, announced its voluntary liquidation. Although SVB only had around 3% of its customer deposits cryptocurrency, it had been compared to Silvergate in the Financial Times two weeks before. On March 9, SVB collapsed on the stock market, unleashing panic. “The fall of Silvergate and the link to SVB caused rumors and misconceptions to spread rapidly across the internet, leading to the start of what would become an unprecedented deposit drain. (…) $42 billion in SVB deposits were withdrawn in 10 hours, or approximately $1 million every second,” Becker explained.

After almost 40 years of existence, Silicon Valley Bank was destroyed in about 40 hours. While trying to obtain liquidity, on the morning of March 10, the FDIC intervened in the entity. That day, another $100 billion was requested to be withdrawn, bringing the sum to $142 billion, 80% of total deposits, in two days. The previous largest leak in US history, that of Washington Mutual in 2008, was $19 billion in 16 days. Deposit insurance was created to prevent banking panics, but in the case of SVB, the vast majority were unguaranteed deposits from investment, venture capital and technology firms, which led the stampede.

“This experience has changed everyone's perception of the possible speed of mass withdrawals. “What in previous episodes occurred in two or three weeks or, in some cases, many months, in the modern era can now occur in hours,” pointed out last December the vice president of Supervision of the Federal Reserve, Michael Barr. “The March 2023 turbulence potentially showed that the growing influence of technological advances, such as mobile banking and the rapid spread of information through electronic communications, could have contributed to the speed of mass deposit withdrawals,” according to the IMF report.

Supervisory failures

SVB was “a textbook case of mismanagement,” in Barr's words. Poor management of interest rate risk and liquidity, that is, on both sides of the balance sheet. Successive autopsies revealed that it was also a textbook case of poor supervision. “The SVB managers fell asleep at the wheel, but so did the regulators,” said Gary Cohn, vice president of IBM who was president of Goldman Sachs, at an event organized by the Brookings Institution this week in Washington. Warning signs arose again and again, but they were not stopped in time. “I was amazed at what Silicon Valley Bank and First Republic Bank were able to do,” said William Demchak, the head of PNC Financial, the eighth largest bank in the United States, at the same event. “Ironically, the measures he finally adopted [el banco] to reinforce their balance sheet they triggered the flight of uninsured depositors that led to bankruptcy,” Barr explained in the Senate. Citibank analysts called the bank's downfall “self-inflicted.”

Following SVB, Signature Bank (SB) and First Republic Bank fell. All three had in common a high concentration of uninsured deposits, significant unrealized losses and exposure to residential real estate credit before bankruptcy. After the fall of SVB and SB, the Federal Reserve tried to calm the waters in two ways: guaranteeing the uninsured deposits of these entities (for this it had to allege systemic risk) and opening a special liquidity window in which banks have came to ask for 165,000 million dollars with debt securities as collateral. The Fed has decided to close it after verifying that banks were using it for arbitrage and making profits.

Deposit leaks are something of a self-fulfilling prophecy. No bank has the liquidity to return the money if all clients ask for it at the same time. That is why banking panics are so dangerous.

Following last year's experiences, the supervisor is monitoring liquidity risk more closely. However, when it comes to regulation, some voices within the Federal Reserve itself warn of the risk of overreacting. “I am very concerned about the road ahead when it comes to regulatory reforms involving liquidity requirements,” Michelle Bowman, central bank advisor, indicated this Friday. “All banks must manage their liquidity, but must have flexibility based on a number of factors, such as risk, business model, size, complexity, funding needs, vulnerability to deposit withdrawals and other considerations. Liquidity requirements, if not properly designed and calibrated, could trap resources that could otherwise be better used, such as loans to banks' customers. Before moving forward, we must identify the gaps in the current framework and lay the foundation for the proposed changes based on research, evidence and data,” he explained.

Another consequence of the crisis was an increase in banking concentration, in two ways. On the one hand, savers sought refuge in the largest entities. On the other hand, due to the purchases of the assets and liabilities of the fallen banks. JP Morgan, which took over First Republic Bank, was the biggest beneficiary in both ways.

The earthquake had its aftershock in Europe, with the fall of Credit Suisse, but it did not trigger a full-blown financial crisis, as the authorities acted to prevent contagion. That is the positive reading. The negative is that “vulnerabilities persist in the US banking sector,” as the IMF maintains.

“Last year's banking stress underscores the importance of not becoming complacent,” Loretta Mester, president of the Federal Reserve Bank of Cleveland, said last week. “We need to holistically examine regulations, our supervisory methods and our role as lender of last resort to address the vulnerabilities that have been revealed,” he added.

NYCB, now on the ropes, was the group that took over most of the liabilities of Signature Bank, one of the banks that fell a year ago. And the pressure also intensifies against a small entity sunk in the stock market whose name has become unfortunate: Republic First Bancorp. Another echo of the crisis of a year ago.

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