Bank Runs: Black Swan or a Flock?

June 21, 2023

Bank Runs: Black Swan or a Flock?

“One black swan is a black swan. Two black swans is a flock”,[1] said Brad Sherman, the US House of Representative from California when highlighting the systematic nature of the crisis after Signature Bank became the second bank to collapse after SVB in March.

Adding First Republic Bank (FRB) to the list (the 14^th largest US lender as of 2022), the flock became larger. JP Morgan Chase (JPC) came to FRB’s rescue by acquiring it on May 1 in a $10.6bn deal[2] brokered by US regulators. With assets totaling $233bn at end-March, FRB is the second-largest bank to fail in US history after Washington Mutual in 2008 and the third since March this year.

There are significant similarities between the FRB and Silicon Valley Bank (SVB) collapse, besides both tracking their origins to California. Both banks had a rather niche clientele, with SVB catering to a slew of tech startups, while FRB served as a go-to bank for high-net-worth individuals. It soon became evident that the $250,000 per depositor insurance coverage provided by the Federal Deposit Insurance Corporation (FDIC) in case of a bank failure was insufficient to meet the needs of the banks’ wealthier clients, creating panic among customers as they queued up to withdraw their hard-earned cash.

Only a handful of depositors covered under the FDIC insurance

Y Combinator CEO Garry Tan stated in a March 10 interview with CNBC[3] that the SVB fiasco would affect about one-third of the 3,000 active ventures funded by the startup accelerator and that about 30% of these companies would not be able to make payrolls in the next 30 days subsequent to the collapse. Tan described the SVB crisis as an “extinction-level” event for the whole start-up echo chamber, which can be explained by a fact that only 2.7% of total SVB clients fell under the FDIC’s $250K bracket as of December 2022 (see figure 1). Signature Bank (SBN), which was the second bank to fail in March, had substantial exposure to relatively riskier crypto assets, while just 6.2% of its clients fell under the $250K FDIC limit (equivalent to about $79.5bn in uninsured deposits as of December 2022). Another crypto-focused lender, Silvergate (SLVG), which had ~$11bn in assets as of last year (relative to ~$114 billion at Signature) and ~39.7% of its customers within the FDIC limit, had to wind down its operations and opt for voluntarily liquidation in March.

Moreover, only 19.8% of FRB customers were fully covered, while JP Morgan, which would go on to acquire FRB in May, had only 32% of its clients fall under the FDIC guarantee. This trend is largely similar across the industry, as the bulk of clients of major US banks such as Northwest Bank (NWB), Wells Fargo (WF), US Bank (USB), Bank of America (BOA), and Citi Group (CITI) had deposits above the $250K limit at the end of last year.

Figure 1: Percentage of total deposits that fell under the FDIC’s $250K insurance limit as of December 2022  

Description: SVB had only 2.7% of its customers fully covered under the FDIC program, meaning 97.3% of its remaining customers had deposits above the $250K limit. Signature Bank and FRB closely follow, with only 6.2% and 19.8% of their total customers eligible for the FDIC guarantee. Source: S&P Capital IQ

On May 4, regulators had to step in to halt the stock trading[4] of PacWest (PACW) and Western Alliance (WAL) after their share prices fell by 50% and 45%, respectively. Although both banks attempted to calm investors, fears of a repeat of the 2008 financial crisis only continued to grow. This was because the Fed increasing US interest rates resulted in a constant devaluation of the Treasury holdings that these banks had maintained during low-rate environment, leaving a hole in their financial position. 

Rate hikes and sector-focused downturn led to record withdrawals

The initial signs of stress in the US banking system first appeared during the fourth quarter of 2022, when SLVG witnessed huge deposit outflows in part due to the bankruptcy of crypto exchange FTX.[5] Just like Signature Bank, SLVG also had significant exposure to crypto assets and specialized in providing services to digital asset firms. To make up for the lost deposits, SLVG was forced to sell its debt securities at huge losses, as bond prices had fallen over the previous 12 months amid the rapid rise in interest rates; the losses proved unsustainable and SLVG had to wind up its operations this past March.

The rise in interest rates also contributed to outflows of US commercial deposits, as customers began to look for other high-yielding assets elsewhere. This resulted in a large decline of bank deposits, which had previously hit a record high of more than $18tn at end-2021 (see figure 2), largely owing to the fiscal response to the COVID-19 pandemic[6] and the Fed’s aggressive quantitative easing during that period. SVB, which had significant exposure to Venture Capital (VC) funds, saw substantial deposit outflows after witnessing a drop in VC funding that most affected the tech sector. Total VC deal value fell to ~$238bn[7] at end-2022, marking a reversal from the record of ~$345bn at end-2021 ensuing from the tech-boom that followed the pandemic. This outflux later combined with the large, interest-rate-driven withdrawals that caused panic among SVB customers, ultimately resulting in the largest bank failure in the US since the 2008 financial crisis, but yet only to be surpassed by FRB two months later. An estimated $42bn[8] was withdrawn from SVB within two days of the March 10 bank seizure announcement. Overall, since the regional banking crisis first unfolded with the liquidation of SLVG in early March, a total of ~$450bn in commercial deposits have been withdrawn from US banks.   

Figure 2: Record commercial deposit outflows following successive rate hikes  

Description: US commercial bank deposits are currently ~$17tn (as seen on the primary Y-axis) after falling from a record ~$18tn at end-2021. The decline in bank deposits is largely due to the successive rate hikes (as seen on the secondary Y-axis) by the US Fed as it aims to bring inflation close to its long-term 2% target. Source: Fred.stlouisfed.org

Unrealized losses on security portfolios mount as interest rates rise

March 2022 served as an “inflection point” as it marked the beginning of the rate hiking cycle and fall in bond prices that transpired along with it. For instance, a 2/32s 10-yr note issued by the US Treasury trading at $101.16 on March 7, 2022, came down to $84.22 one year later, delivering a negative return of 16.7%. Banks’ commercial deposits had previously surged during the pandemic when interest rates were low and the Fed’s bond-buying program was in full swing. Many banks funneled this inflow of deposits to boosting their liquid portfolio of debt securities, which had increased to 26% of their total assets by end-2022 (as shown on secondary Y-axis in figure 3). As interest rates started to rise in tandem with the Fed’s tightening cycle, unrealized losses on these securities mounted to ~$620bn in Q4 2022 (as shown on primary Y-axis in figure 3). Although this amount has fallen to ~$515bn as of Q1 2023 as per the most recent FDIC Quarterly Banking Profile report, the US banking sector still remains deeply under stress.

SVB last year had invested $127bn[9] in bonds, thus boosting its debt security portfolio to more than 50% of its $212bn in total assets by December 2022. The bank had to take a $1.8bn hit in unrealized losses after it decided to sell its $21bn of its ‘available-for-sale’ securities at a negotiated price to calm investors, but this in turn only raised further fears that, ultimately, led to its demise.

Figure 3: Unrealized gains/losses on securities and their share relative to total assets

Description: Industry-wide losses on investment securities reached $620bn (as seen on the primary Y-axis) in Q4 2022, and although they have fallen to $515bn as of Q1 2023, they remain at elevated levels. Meanwhile, debt securities as a % of total assets had risen to 26% at end-2022 (as seen on the secondary Y-axis), showing US banks’ exposure to Treasury securities and their associated price risks due to the rise in interest rates. Source: FDIC and US Federal Reserve

Fed’s Bank Term Funding Program (BTFP) vs. lending through the discount window

The BTFP is also seen as a ‘lender of last resort’[10] facility. The $25bn-lending program came into existence in March this year to shore up confidence in the regional banking sector after the unrealized losses on long-term bond holdings led to the collapse of Silicon Valley and Signature bank. The BTFP offers loans of up to one year to all depository institutions, including banks, savings associations, and credit unions among others that pledge Treasury securities, agency debt, mortgage-backed securities (MBS), and other qualifying assets as collateral. Under the BTFP, these assets will be valued at par, meaning the financial institutions will be able to exchange assets for cash at face value regardless of their current market price, thus significantly reducing the risk that deposit outflows will lead to bank runs. It is important to note that the BTFP is a temporary measure and is expected to provide additional liquidity to banks only until March 2024. Total borrowings from this facility had risen to a little over $100bn (see figure 4) on the week ending on Monday, June 5, and the interest rate at which these loans are provided currently stands at 5.22%, which is calculated by placing the latter 10bps above the current 1-yr OIS (Overnight Index Swap).

Unlike the BTFP, borrowings from the discount window are permanent. Under this arrangement, banks can have access to primary credit by pledging securities at market value, unlike the BTFP that values the assets at par, which has made the BTFP the preferred facility from which to take out loans. In the wake of this temporary emergency measure, lending through the traditional discount window has fallen to ~$3.2bn as of June 5 from over ~$150bn in early March this year (see figure 4). The Fed previously charged 1-5% in haircuts depending on the duration of securities to make sure the collateral pledged by the banks was enough to cover the loan. However, the collapse of SVB led the Fed to eliminate those haircuts altogether. The discount rate on primary credit as of June 9 is 5.25%[11].   

Figure 4: Borrowings from the Fed’s BTFP facility surge above $100bn as of June 5

Description: Borrowings from the Fed’s BTFP have surged above $100bn as of June 5, pointing to the stress in US banking sector, with demand for loans from the ‘lender of last resort’ picking up to its highest levels since the facility came into existence in March. Meanwhile, borrowings through the more traditional discount window have fallen to $3.2bn from over $150bn in early-March 2023. Source: FDIC and US Federal Reserve

Conclusion: Beyond emergency measures…

Despite similarities, the current regional banking crisis is different from 2008 given a fact that the distress in financial sector occurred after the Fed started to raise interest rates in March last year, while in 2008 the rates were cut to near-zero after the crisis hit the financial sector and were maintained at that level till December 2015. The idea of introducing the BTFP was to provide emergency liquidity to banks and also use the facility as a cushion against future rate hikes. The policy action was further reaffirmed after Fed officials indicated that more rate hikes would likely follow later in the year after ‘skipping’ a rate increase at the June FOMC meeting.[12] The Fed’s emergency loans to financial institutions will serve as a backstop until March 2024 in the case there are deposit outflows like those that occurred during Q1 2023.  

The $250,000 insurance limit was revoked to both cover depositors at SVB and Signature bank up to their full amount and limit contagion risk in the banking sector. As this limit fell too short to serve the high-end clients of SVB and First Republic, the FDIC has called for boosting the deposit insurance limit for business payment accounts, although it did not outline the appropriate limit in its report.[13] Banks’ commercial lending practices have also come under the radar as regulators prepare to tighten up capital and liquidity rules for banks with more than $100bn in assets. The proposed rules[14] could require banks to start reporting on their books the unrealized losses stemming from their security investments, which had swollen to more than $600bn at end-2022.

Although borrowings through the BTFP have become the preferred platform for banks in need of immediate cash, more efforts are needed to make traditional lending through a permanent discount window a viable option. Total borrowings through the BTFP since the emergency lending program was initiated have surged to a record ~$100bn as of June 5, while lending through the permanent discount window has fallen by ~98% to just ~$3.2bn during this period. It is to be noted that the BTFP is a temporary facility and will continue to operate only until March 2024, increasing the urgency for regulators to make the terms of traditional lending as attractive as those of the emergency program. The terms under the BTFP allows banks to pledge their securities at par value, while bonds undertaken as collateral under traditional lending are valued at market price, thus prompting banks to rush to the temporary facility. The proposed rules to monitor capital levels and liquidity at major banks would help in boosting the risk profile of small, medium-sized, and big banks, but more work is needed to ensure that access to primary credit is relatively smooth, given it will soon be the sole option for banks in need of additional liquidity.