Would Bank Failures Lead to Another 2008-Style Crash?

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Will bank runs lead to another 2008 style crash?

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Despite recent bank runs, we are not heading for a repeat of the 2008 disaster, but that does not mean the economy is in excellent shape.

Introduction

Silicon Valley Bank, a lender to some of the biggest names in technology, failed on March 10, becoming the largest bank failure since the 2008 financial crisis. By Sunday night, regulators had quickly shut down Signature Bank in order to avert a financial system disaster. The sudden closures of the banks have sent shockwaves across the tech industry, Washington, and Wall Street.

The global economy has been through a lot in recent years. From the financial crisis of 2008 to the ongoing COVID-19 pandemic, there have been many challenges to overcome. However, given the latest collapse of Silicon Valley Bank and Signature Bank, there is a new threat on the horizon that could potentially cause even greater harm – banking failures. In this article, we will explore the potential impact of banking failures on the global economy and what steps can be taken to mitigate this risk.

The Current Situation – The Failure of Silicon Valley Bank and Signature Bank

Despite recent bank runs, we are not heading for a repeat of the 2008 calamity, but that does not mean the economy is in excellent shape. It goes without saying that the recent failures of Silicon Valley Bank and Signature Bank, as well as the Swiss National Bank facilitating UBS’ $3.2 billion purchase of Credit Suisse, First Republic Bank’s stock falling more than 70%, and bank stocks in general, have alarmed investors of all stripes. Many people appear to believe that a financial catastrophe similar to the one that occurred in 2008.

While it is crucial not to minimize the gravity of our current predicament, there are significant contrasts that render these two tragedies incomparable.

For starters, Lehman Brothers was an investment bank, whereas Silicon Valley Bank and Signature Bank were commercial banks. Despite Silicon Valley Bank being the second largest bank failure in American history, the magnitude was considerably different. In 2008, Lehman Brothers’ assets totaled $600 billion. Silicon Valley Bank has $198 billion in assets. Silicon Valley Bank was almost 20% the size of Lehman Brothers after adjusting for 15 years of inflation.

Even more importantly, the assets that triggered the runs on Lehman Brothers and Silicon Valley Bank are as dissimilar as they can be. It was a series of highly leveraged derivatives secured against highly leveraged mortgages supplied to unqualified buyers that were becoming overdue en masse for Lehman Brothers.

The asset in dispute with Silicon Valley Bank were fully performing bonds, which were allegedly among the safest assets available.

While this may appear strange, the decisions taken by Silicon Valley Bank were nearly as perplexing as those made by Lehman Brothers, given the circumstances.

Now let us begin by delving deeper and explaining what happened to them.

Why Did Silicon Valley Bank and Signature Bank Fail?

The most drastic interest rate tightening in history, following a prolonged period of interest rates being as low as they had ever been, created the stage for Silicon Valley Bank and Signature Bank’s downfall. Furthermore, in the case of Silicon Valley Bank, it was truly believing what the Fed indicated in 2021. They apparently trusted Jerome Powell when he declared that “inflation would be transitory.”

Since the financial crisis of 2008, the Fed has regularly held interest rates at or near zero. They finally began to raise them a little, but then Covid hit, and the Fed pushed them straight back down. Despite the government pumping trillions of dollars into the economy through various stimulus packages, they kept rates around zero until 2021. The indicators of inflation taking root were as obvious as day.

Low interest rates can stimulate economic activity and enhance productivity, but they can also cause inflation, economic inequality, and, most importantly, a feverish chase for yield.

When interest rates are so low, any “risk-free” asset (such as money market accounts, treasury bonds, etc.) has a return close to zero. Banks offered roughly a 0.1% interest on savings accounts in 2021. That was roughly 0.5% in a money market account. You might as well have hidden your money under a mattress.

Silicon Valley Bank was the go-to bank for tech startups and Silicon Valley enterprises, which experienced a massive surge during Covid. This resulted in a tremendous rise in depositors for Silicon Valley Bank. Deposits at the bank increased from $49 billion in 2018 to $102 billion in 2020, $189.2 billion in 2021, and $198 billion in 2022.

Silicon Valley Bank committed a crucial error at this point. They were on the lookout for yield. They spent $80 billion on mortgage-backed securities with maturities of more than ten years and a weighted average yield of 1.56%.

1.56% may appear low, but consider what options were available for “low-risk” bonds in 2021.

Then came the fastest interest rate hike in history, and the yield on 10-year mortgage-backed securities followed behind.

As a result, the returns on these “low-risk” investments were less than half of the market value. Needless to say, the value of such bonds plunged. But there was one more crucial aspect to these ties. They are what is known as “held-to-maturity.” With this objective, the goal is to hold the bonds until maturity.

But what this actually means is that these bonds do not need to be revalued until and until they are sold. As a result, Silicon Valley Bank was sitting on a massive pile of unrealized losses that amounted to a house of cards. Just check their own report from 2021, before any grey clouds arrived on the horizon, to see how many of these HTM bonds they had (in purple below).

Then, in late 2022, the tech bubble will implode. Facebook laid off almost 10,000 employees twice, Amazon laid off 9,000 after laying off 18,000 previously, Twitter laid off nearly 4,000, and a slew of other tech firms did as well. The Covid-fueled tech boom had ended, putting severe strain on a tech-dependent bank’s deposits.

In addition, inflation is reducing people’s savings and, as a result, bank deposits in general.

Silicon Valley Bank was forced to increase capital as a result of the pressure on its deposits. But, selling those HTM bonds forced them to realize those unrealized losses because selling one requires revaluing the entire portfolio.

Later, Silicon Valley Bank CEO Greg Becker had a catastrophic investor call. Greg Becker stated on the call that Silicon Valley Bank would incur a $1.8 billion after-tax loss on the sale of several of these bonds and would need to raise $2.25 billion. As one might imagine from a “don’t panic” call, it sparked a panic and a bank run.

Silicon Valley Bank, like practically other banks, practices fractional reserve banking, which implies that a bank only has to retain a portion of the deposits it accepts on hand—typically 10%. It can lend out the remaining 90%. (But now it’s technically zero reserve banking, but that’s another topic).

For example, if a bank has a 10% reserve and $1,000 in deposits, it can make around $900 in loans. The bank is obligated by law to keep at least 10% in reserves. As a result, if everyone requests for their money back at the same moment, the bank will fail, because they only have 10% in stock. There have been several bank runs throughout American history.

Signature Bank likewise suffered $762 million in unrealized losses from the identical HTM bonds that bankrupted Silicon Valley Bank. They did, however, have some more evident issues.

Apart from being the subject of a criminal investigation before to their demise, crypto clients made up around 20% of Signature Bank’s deposits. For anyone who may have forgotten, here’s what happened to Bitcoin during the previous years.

Despite these evident issues, there is still considerable uncertainty regarding what exactly prompted authorities to liquidate Signature Bank.

Others have speculated that the crisis was triggered by a bank deregulation bill passed in 2018. Some oversights, notably related stress testing, were removed from so-called regional banks with less than $250 billion in assets under the measure.

This deregulation may have exacerbated the situation, but it appears to be a secondary factor. I’ve seen little indication that Silicon Valley Bank lacked adequate cash reserves. It also lacked “toxic assets,” such as the collateral debt obligations with stacks of unpaid loans from 2008. What doomed these institutions was keeping a huge quantity of ostensibly secure fixed-income assets in an inflationary climate.

The primary factors were the quick rise in interest rates and the unusual manner in which HTM bonds were priced. And it was Silicon Valley Bank’s and, to a lesser extent, Signature Bank’s inadequate risk management and inability to anticipate the impending rise in interest rates that killed them.

What Does This Mean for the Economy?

Unlike Lehman Brothers, Silicon Valley Bank and Signature Bank were neither investment banks nor major middlemen. Silicon Valley Bank was closely associated with technology, whereas Signature Bank was associated with cryptocurrency.

In general, there are two ways for a bank to fail: insolvency and illiquidity. Insolvency occurs when the bank’s assets are less valuable than its liabilities. This was true of Lehman Brothers. SVB and Signature are both illiquidity bankruptcies, which are less damaging because the bank’s assets aren’t completely toxic. They just cannot meet their immediate duties. Indeed, when Silicon Valley Bank’s assets are auctioned off, the bank will not suffer a total loss. As a result, these bank failures are unlikely to constitute the start of an economic catastrophe like the one that occurred in 2008. Regrettably, it creates a huge difficulty for the Federal Reserve and likely indicates that we will be in an economic slump for some time.

Prior to any of these bankruptcies or Credit Suisse’s takeover, the FDIC revealed that there were $620 billion in unrealized losses on the bank’s balance sheets from the same type of HTM bonds that drove Silicon Valley Bank down. Interest rate increases were to blame for these losses. This was done to combat inflation.

While inflation has slowed slightly, it remains high at more than 6%. As a result, the Fed is caught between a rock and a hard place.

The Federal Reserve’s Dilemma

If you had to come up with a hypothetical scenario of how a central bank might mismanage the economy as terribly as feasibly conceivable, it would be difficult to come up with anything worse than how the Federal Reserve performed between 2021 and the end of 2022.

First, they kept rates at all-time lows until 2021, despite the fact that the economy was performing well and real estate values were surging. Then they grossly overestimated inflation and raised rates quicker than at any other period in history to combat the unanticipated inflation, resulting in this tremendous glut of unrealized bank losses and other economic discombobulations.

Every central bank’s mission should be to maintain stability, and it’s difficult to see how they could have failed to do so.

They are now in a terrible catch-22 situation as a result of their own stupidity. Even before the recent bank failures, the Fed had indicated that it would halt its rate hikes. They may now be reconsidering their entire policy in this regard.

All else being equal, the more money poured into the economy, the more inflation there will be. This is one of the reasons why raising interest rates tends to reduce inflation. It has a negative impact on economic activity and the number of bank loans. Furthermore, due to fractional reserve banking, bank loans contribute money to the economy, whilst paying them off (or loans becoming late) subtracts money from the economy. (Read here for a more extensive explanation).

In contrast to the 2008 TARP, Silicon Valley Bank and Signature Bank were not bailed out. Yet, despite the fact that FDIC insurance ostensibly caps deposit insurance at $250,000.

Many businesses would have been unable to pay their employees if the FDIC had not stepped in. Another concern is whether it is appropriate to make the rest of us pay for their deposits. Nonetheless, it is apparent that doing so put a significant amount of money into the economy. JPMorgan estimates that the Fed’s emergency efforts will have added $2 trillion to the banking system.

If they keep hiking interest rates, the unrealized losses will grow correspondingly, and more banks will fail. If they don’t, any progress made in combating inflation will certainly stagnate and reverse, and high inflation will likely be with us for the foreseeable future.

The Fed has already made a mistake by bailing out depositors.

Will they flinch even more by stopping the rate hikes? Will they, in fact, lower them?

In any case, they’ve pushed themselves into a hole, and the economy will suffer in some way. Investors should not anticipate a 2008-style crash. Yet, they should surely expect continued volatility and a protracted economic depression. Unlike the 2008 TARP, Silicon Valley Bank and Signature Bank were not involved.

General Background:

The Causes of Banking Failures:

There are many reasons why a bank may fail. Some of the most common causes include a lack of liquidity, bad loans, fraud, and mismanagement. When a bank fails, it can have a ripple effect throughout the entire financial system. Depositors may lose their savings, loans may default, and other banks may become reluctant to lend money. This can lead to a contraction of credit, which can have a negative impact on economic growth.

The Consequences of Banking Failures:

The consequences of banking failures can be severe. In addition to the loss of savings and the contraction of credit, there can also be a loss of confidence in the financial system. This can lead to a run on other banks, which can exacerbate the problem. In extreme cases, a banking crisis can lead to a recession or even a depression. This is why it is so important to take steps to prevent banking failures from occurring in the first place.

Preventing Banking Failures:

Preventing banking failures requires a multifaceted approach. One of the most important steps is to ensure that banks are well-regulated and well-capitalized. This means that they have enough money on hand to cover any losses that may occur. Additionally, banks should be required to perform regular stress tests to identify potential weaknesses in their business models. This can help to prevent failures before they occur.

Another important step is to promote transparency in the financial system. This means making sure that banks are reporting their financial results accurately and that regulators have access to all relevant information. It also means encouraging whistleblowers to come forward with information about potential wrongdoing.

Conclusion:

In conclusion, banking failures represent a significant threat to the global economy. They can lead to the loss of savings, the contraction of credit, and a loss of confidence in the financial system. However, by taking steps to prevent failures from occurring in the first place, we can help to mitigate this risk. This requires a combination of effective regulation, transparency, and stress testing. By working together, we can help to ensure that the global economy remains strong and stable in the face of any challenges that may arise.

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