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How deep is corruption in the US banking industry?

Banking is Confidence trick. Financial history is full of runs, for the straightforward reason that no bank can survive if enough depositors want to be paid at the same time. Thus, the trick is to ensure that there is no reason to withdraw money from customers at all. He’s one of the bosses at Silicon Valley Bank (svb), once the 16th largest US lender, failed to perform at a crucial moment.

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Dropp off svb, a 40-year-old bank built to cater to the tech scene in the Bay Area, took less than 40 hours. On March 8th, the lender said it would issue more than $2 billion in principal, in part to cover bond losses. This led to an audit of its balance sheet, which revealed that about half of its assets were long-term bonds, many of which were underwater. In response, deposits worth $42 billion were withdrawn, a quarter of the bank’s total. At noon on March 10, the organizers announced this svb to fail.

Maybe it was a one time thing. svbThe company’s business – banking for techies – was extraordinary. Most of the clients were companies with more than $250,000 protected by the Federal Deposit Insurance Corporation (FDIC).Fdik) , Organizer. If the bank fails they will face losses. And svb Use deposits to buy long-term bonds at the peak of the market. “One would assume that a Silicon Valley bank would be a good candidate to fail without infection,” says Larry Summers, former Treasury secretary. However, withdrawal requests from other regional banks in the following days showed “there was, in fact, significant infection.”

Hence the intervention of the authorities. Before the markets reopened on March 13, the Federal Reserve and the Treasury Department revealed that Signature Bank, a New York-based lender, had also failed. They announced two measures to guard against more landslides. First, all depositors in svb And the signature will become complete and direct. Second, the Federal Reserve will create a new emergency lending facility, the Term Bank Financing Program. This would allow banks to deposit high-quality assets, such as Treasury bills or mortgage securities backed by government agencies, for a cash advance equal to the face value of the asset, rather than its market value. Thus, the banks that loaded on the bonds whose price fell will be protected from svbfate.

These events raise profound questions about America’s banking system. Post-financial crisis regulation was supposed to stuff banks with capital, increase their cash reserves, and reduce the risks they were able to take. The Fed was supposed to have the tools it needed to ensure that affluent institutions stayed in business. Crucially, it is a lender of last resort, able to swap cash for good collateral at a penalty rate in its own “discount window”. Acting as a lender of last resort is one of the most important functions of any central bank. As Walter Bagehot, former editor of the The Economist, writing 150 years ago in Lombard Street, the function of the central bank is to “lend panic on every type of security present, or every type on which money is ordinarily lent”. This “may not save the bank; but if it does not, nothing will save it.”

The interventions of the Fed and the Treasury Department were of the kind expected in any crisis. They fundamentally reshaped America’s financial structure. However, at first glance, the problem seemed to be poor risk management in one bank. “Either this was an inexcusable overreaction, or there is much more corruption in the American banking system than any of us outside classified supervisory information could ever know,” says Peter Conte Brown, a financial historian at the University of Pennsylvania. So what is it?

To assess the possibilities, it is important to understand how changes in interest rates affect financial institutions. A bank’s balance sheet is a mirror image of its customers. It owes the money of depositors. The loans people owe are their assets. At the beginning of 2022, when interest rates were close to zero, US banks held $24 trillion in assets. About $3.4 trillion of that amount was cash on hand to pay off depositors. About $6 trillion was in securities, mostly Treasury or mortgage-backed securities. Another $11.2 trillion was in loans. US banks financed these assets with a huge deposit base of $19 trillion, almost half of which is insured by Fdik And half was not. To protect against losses in their assets, the banks held $2 trillion in “tier one equity,” of the highest quality.

Then interest rates jumped to 4.5%. svbThis decline drew attention to the fact that the value of banks’ portfolios had fallen as a result of the rise in interest rates, and that this blow had not been identified on the balance sheets. the Fdik Reports indicate that, in total, US financial institutions have $620 billion in unrealized market losses. It is possible, as many have, to compare these losses to stock bank losses and to panic. Altogether, a 10% hit to bond portfolios would, if realized, wipe out more than a quarter of banks’ equity. The financial system may have been well capitalized a year ago, the argument goes, but much of that capitalization has been de-capitalized at higher rates.

The exercise becomes more troubling when other assets are adjusted for higher rates, as did Erica Jiang of the University of Southern California and co-authors. For example, there is no real economic difference between a ten-year bond with a 2% coupon and a ten-year loan with a fixed interest rate of 2%. If the value of the bond decreases by 15%, the value of the loan decreases as well. Some of the assets will be floating rate loans, where the rate goes up with market rates. Helpfully, the data the researchers collected breaks down loans into fixed and floating rate loans. This allows the authors to analyze only fixed-rate loans. Results? The banks’ assets would be $2 trillion less than the amount advertised – enough to wipe out all equity in the US banking system. Although some of this risk can be hedged, it is expensive to do so and banks are unlikely to have done much of it.

But as Jiang and co-authors point out, there is a problem with stopping the analysis here: the value of the offset deposit base has not been re-evaluated either. It is much more valuable than it was a year ago. Financial institutions usually do not pay anything at all on deposits. These are also very sticky, as depositors store money in checking accounts for years on end. Meanwhile, thanks to rising interest rates, the price of zero-coupon ten-year bonds has fallen by about 20% since early 2022. That means the value of ten-year 0% borrowing power, which is a constant, provides the deposit base. Low cost in fact, it’s worth 20% more than it was last year – more than enough to offset the losses on the bank’s assets.

Thus, the real risk for the bank depends on both the deposits and the behavior of depositors. When prices rise, customers can move their money into money market or high-yield savings accounts. This increases the cost of bank financing, although usually not by that much. Sometimes – if the bank gets into extreme difficulties – deposits can disappear overnight, eg svb discovered in a devastating way. Banks with large, sticky, low-cost deposits need not worry about the market value of their assets. By contrast, banks with spotty deposits do a lot more. As Huw van Steenis of the consulting firm Oliver Wyman notes: “Paper losses only become real losses when they crystallize.”

How many banks have loaded securities, or made a lot of fixed-rate loans, and are uncomfortably exposed to bad deposits? Insured deposits are the stickiest because they are protected if things go wrong. So Jiang and co-authors considered Criticism Uninsured. They found that if half of these deposits were withdrawn, the remaining assets and equity of the 190 US banks would not be sufficient to cover the rest of their deposits. These banks currently hold $300 billion in insured deposits.

The newfound ability to exchange assets for their face value, under the bank’s term financing program, at least makes it easier for banks to pay depositors. But even this is just a temporary solution. As for the new Fed facility, that is itself a confidence trick. The program will support troubled banks only as long as depositors believe it will. Borrowing is done through the facilities at market rates of about 4.5%. This means that if the interest income the bank is earning on its assets is less than that—and its deposits are left low-cost—the institution will simply die from a quarterly net interest income loss, rather than a quick death caused by the bank’s operation.

That’s why Larry Fink, president of BlackRock, a large asset management firm, warned of a “slow-release crisis.” He expects this to involve “more seizures and shutdowns”. High interest rates revealed the kind of asset-liability mismatch that was made svb It is, he believes, “a price to pay for decades of easy money.” UPenn’s Conti Brown points out that there are historical parallels, the most obvious being bank losses that spiraled in the 1980s when Paul Volcker, then-Fed chairman, raised interest rates.

Rising rates exposed problems in bond portfolios first, as markets show in real time how these assets fall in value when interest rates rise. But bonds are not the only assets that carry risks when policy changes. “The difference between interest rate risk and credit risk can be quite subtle,” notes Conte Brown, as eventually higher interest rates will put pressure on borrowers as well. In the 1980s, the first banks to fail were those in which asset values ​​fell as interest rates rose – but the crisis also exposed the bad assets within American “savings”, the specialized consumer banks, in the end. Thus, the pessimists worry that now that banks fail because of rising rates is just the first domino to collapse.

The result of all this is that the banking system is much more fragile than was imagined – by regulators, investors and perhaps the bankers themselves – before last week. Obviously, smaller banks with uninsured deposits will need to raise capital soon. Torsten Slok of Apollo, a private equity firm, points out that a third of the assets in the US banking system are held by smaller banks svb. All of these will now tighten lending in an effort to strengthen their balance sheets.

One lesson that regulators must learn is that medium-sized banks can be too big to fail svb. This incident also turned other aphorisms of post-crisis finance on their head. After 2008, investors thought that deposits were safe, and market financing was very risky. They also believed that Treasuries were safe and loans risky,” says Angel Obaid of Citadel, a hedge fund. “All post-crisis rulebooks were written on this basis. Now the opposite appears to be the case.” One example, however, remains intact. Problems in the financial system never emerge from closely watched places.

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