- Four U.S. bank failures beginning with SVB rattled the banking world in March.
- Banks have serious problems of declining revenue and negative interest margin.
A slew of failures rattled the banking world in early March. It included four US banks and a major European investment bank. Below is a summary of what happened, and my take on why. Understanding the reasons will allow us to make an educated guess on whether the pressure on banks will continue.
First, let us note how partial reserve banking works. Banks today are required to keep 8.5% of assets in liquid reserves, while the rest is given out as loans. That’s why large withdrawals present a problem. Even the 8.5% reserve itself, typically invested in Treasuries, might lose value – see more on this below. Withdrawals that approach the amount of reserves – a “run on a bank” – lead to its insolvency.
What Happened
The debacle began quietly on March 8th when California’s Silvergate Capital announced voluntarily liquidation. The “cryptocurrency bank” faced billions in withdrawals after a collapse in the crypto market in recent months.
Two days later, California’s Silicon Valley Bank (SVB) collapsed. It experienced sharp deposit outflows in early March that totaled $42 billion. The bank’s desperate attempt to raise capital by selling stock failed, and it was shut down and taken over by the FDIC on Friday, March 10th. SVB was quite large – the country’s 16th largest bank with $209 billion in assets. It became the second largest bank failure in U.S. history, after Washington Mutual during the height of the 2008 financial crisis. Its business was focused on venture capital and technology clients.
On the heels of SVB’s failure, concerns about the banking industry spread as investors turned their focus to several other regional banks. The regional bank index plunged by 30% (see chart below), and many bank shares by 70-80% in just a week. First Republic, a San Francisco lender that served the venture capital and tech space, saw deposit outflows that were later estimated to total $70 billion. It was forced by regulators to be acquired by First Citizens Bank later in March.
On March 12th, regulators unexpectedly shut down Signature Bank in New York which had also focused on venture capital and tech clients – it became the third largest bank failure in U.S. history, with $118 billion in assets.
All failed banks seem to be connected to the venture capital space. As IPOs dried up las year due to the stock market decline and the crypto debacle, some VC firms found themselves short of cash.
SPDR S&P Regional Banking ETF (KRE), 1 Year
Source: Yahoo Finance
The crisis also reached Europe with Swiss second-largest bank Credit Suisse in the center, which faced declining revenue and net loss for years. The Swiss government forced it to be acquired by its larger rival UBS on that day for meager $3.24 billion – 30% of its market cap just two weeks ago.
Fundamental Problems
The regulators learned their lesson from 2007-08. This time, they stepped in quickly to halt the spreading bank runs. But bank problems are fundamental and broad, going beyond the venture capital space or safety of deposits in a handful of banks. As I see it, these problems fall into three categories:
- Dropping lending volume (bank revenue);
- Dropping/negative net interest margin (bank income);
- Declining asset values.
Let me briefly cover each item today, and I might add more detail in future articles.
Existing Home Sales, 25 Years
Lending is banks’ primary business, directly impacting the top line – and it dropped substantially over the course of 2022. This is evident in mortgage applications, home sales (that drive mortgage issuance) and the overall credit growth reported by the Fed. For example, existing home sales plunged from over 6 million in 2021 to 4m–4.6m annual rate (see chart above). If they stabilize around, say, 4.5m this year, it will make a drop of 25%. In 27 years, excluding a brief period in 2020 in the midst of COVID pandemic, sales have only been lower in 2008 and 2010.
The second problem impacts bank profit margins. Banks borrow (mostly) short-term and make longer-term loans. Normally, the spread between long and short-term rates is positive (a “normal” yield curve), giving banks a positive net interest margin. Banks need the margin to be substantial, larger than 1%, to cover their expenses. Today, however, the yield curve is inverted by more than 1% (see chart below), giving banks a substantially-negative margin. So, banks are facing interest losses on most of their lending.
Source: US Treasury
This has happened before – an inverted yield curve decimated the bank and savings & loans industry in the 1980s.
A mitigating factor is that deposits are still low-cost as customers got used to low interest after years of near-zero rates. But this is changing – customers seek higher rates, and bankers are forced to raise them to attract new depositors or even to keep them from fleeing.
The third problem is declining asset values. Banks invest their reserves in Treasury notes and MBS, and their values have dropped due to rising market yields. For example, 7-10 year Treasuries were trading at a 16% loss from two years ago at the beginning of March (see chart below), when the failing banks had to sell them to pay out fleeing depositors.
However, longer-term yields decreased somewhat and bond values rose in March. While not nearly eliminating this problem for banks, I expect it to improve going forward.
iShares 7-10 Year Treasury Bond ETF (IEF), 2 Years
Source: Yahoo Finance
To summarize, while the banks that failed in March all seem to be connected to the venture capital space, the banking industry itself has serious fundamental problems of declining revenue and negative interest margin. These problems have worsened over the course of 2022: lending declined, and the yield curve became the most inverted since 1981.
Let us keep in mind that 2022 was a year of economic growth. The economy is now slowing. An inverted yield curve is considered a reliable recession warning: it has preceded all eight of recent recessions. If it’s right once again, we might have a recession in 2023, with many additional problems for banks including deteriorating creditworthiness of borrowers and collateral values.
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