Commentary
Putting aside fraud or criminal activity, banks usually fail in one of two ways: through insolvency or illiquidity (or both). Insolvency occurs when the bank doesn’t have enough assets to cover its liabilities. Insolvency tends to emerge gradually: for example, when it develops from deteriorating “main street” economic conditions. On the other hand, illiquidity leads to insolvency much more quickly. Illiquidity results when the bank doesn’t have enough cash on hand to meet its customers’ demands for it, and this can occur rapidly. Deposit runs are one of the main ways a bank can suddenly find itself in a liquidity crisis, which eventually spirals into insolvency.If many large depositors show up all at once demanding their money back, which was the case with Silicon Valley Bank (SVB) and First Republic, the bank, which only has a limited amount of cash on hand at any one time, may be forced to sell other assets, such as investment securities or loans. Rushed and panicked selling in difficult market conditions forces the bank to sell assets for less than their book or intrinsic value. When this happens, the difference between book value and realized value upon a sale results in a loss, depleting capital. Eventually, the bank becomes undercapitalized, or, even worse, finds itself in a deficit, owing more than it owns. Regulators then step in.
And this is what turns a liquidity crisis into a solvency crisis. With differing details, it’s what has happened time and time again over the past two months, resulting in three of the four largest bank failures in U.S. history.
The banking liquidity crisis of 2008 sprang from different sources but had the same net effect. Rather than losing depositors, the investment banks such as Bear Stearns, Lehman Brothers, Citigroup, and others lost access to wholesale funding lines, which, rather than being provided by business and individual customers, came from other banks, hedge funds, money market funds, insurance companies, and other financial institutions. The result was the same. With liquidity drying up amid the howling fear of those days, the banks were forced to sell assets on the cheap, creating a downward spiral.
When wholesale funders got nervous, they pulled their lines. This happened in a matter of hours and days, often in the form of overnight repo loans that wouldn’t renew. The surviving “too big to fail” (TBTF) investment banks such as Goldman Sachs, Morgan Stanley, and others were fast-tracked to become deposit-gathering institutions regulated by the Federal Reserve, which also gave them access to the Fed’s discount window, where, in an emergency, they could pledge as collateral quality assets in exchange for quick cash. And now they could also appeal to businesses and individuals for deposits.
No Bank Can Withstand a Deposit Run
If you take away anything from this article, it is this: No bank is safe from a deposit run once its wheels are fully in motion—not the TBTF banks, not even mighty JP Morgan. Deposit runs are often driven by irrational psychological phenomena, the so-called madness of crowds, not facts or figures concerning the underlying financial condition of the bank. Nonetheless, they create self-fulfilling prophecies by setting in motion the spiral of liquidity and then solvency issues described above.Perversely, it’s the biggest TBTF and regional banks that may be most at risk. As public companies, details of their financial results are interrogated by investors every quarter. Every snippet of negative news in a Securities and Exchange Commission filing or press release raises the question “What does it mean—is something wrong?” Banks of all sizes are required to make weekly regulatory filings that are publicly available to the intrepid analyst or researcher willing to dig. Yet the TBTF and regional banks, by virtue of size and importance, are more visible and much more heavily scrutinized.
This means that they’re also more exposed to the momentum of investment blogs, social media, and real-life social networks. Why did SVB fail when it did? Not because it was insolvent, or—at least initially—illiquid, but because SVB’s venture capital customers fueled and circulated rumors that there was a liquidity problem at the bank. And, in an example of manifestation or prophetic utterance, so it was. The same was true for First Republic. In the absence of swirling rumors that led to short-sellers and depositors alike targeting the bank, First Republic likely would have lived to fight another day.
And this is the point: When the all-seeing eye of the market decides—for whatever reason, rational or not—to turn its focus to the next one (or several) of the TBTF or regional banks that have underlying issues and challenges, what stands in the way of the next massive bank failure?
In this scenario, the Federal Deposit Insurance Corp. would be all but useless. Its $128 billion Deposit Insurance Fund is less than 10 percent of total deposits. It has already absorbed some $35 billion in projected losses from the recent bank failures. Only the Federal Reserve’s discount window and emergency funding lines would make a meaningful difference. If the Fed starts buying assets again, inflationary forces would regain the upper hand, erasing the moderation in price rises we’ve seen in the past few months. The Fed’s balance sheet is already more than $8 billion, up tenfold since the global financial crisis, while total banking system deposits are more than $17 billion. One institution, JPMorgan Chase, now holds $1 in every $10 of deposits.
While there has been a lot of talk recently about the small community banks being at elevated risk because of higher exposure to problems in commercial real estate markets—and this is true—perhaps the real risk lies with those TBTF and regional banks clearly in the spotlight and subject to the vagaries of market sentiment and an investor psychology tilting toward fear and panic.
On the other hand, by their very name, community banks benefit from intangible loyalties and local alliances that the bigger banks, often anonymous and amorphous, don’t have. The community banks, usually privately held by local shareholders, trusts, or mutuals, which same entities are often also the core depositors, may actually prove to be the safer harbor in the banking storm that has yet to fully pass.
