Three Out of the Four Largest Bank Failures in U.S. History Happened This Year: Have the Banking Sector Risks Passed?
It’s not unusual for banks to fail. Even when the economy is healthy, four or five banks may fail per year. Like any industry, banking is subject to competitive pressures. Sometimes business decisions lead to success, and a bank’s profit grows. Other times, business decisions, coupled with bleak economic conditions, result in losses. In banking, such losses can lead to a sudden drop in confidence among the bank’s customers, the depositors demand their money, and the run on the bank causes a quick collapse.
While failures are common, the role banks serve in the economy necessitates a robust set of guardrails to ensure that the bank failures don’t result in a systemic issue, such as the one we saw in the 2007/08 subprime crisis. During that time, some of the distressed banks were large enough that their collapse would have meant catastrophic damage to the economy. The Fed took unprecedented steps to support these banks with direct assistance, and the “too big to fail” moniker was born.
Since the subprime crisis, interest rates have been held historically low, and regulations have loosened. Not a single bank failed in 2021 or 2022. The banking system hummed along until earlier this year, when First Republic Bank, Silicon Valley Bank (SVB), and Signature Bank became numbers two through four, respectively, on the list of the largest bank failures in US history. These three regional banks were large enough to cause systemic concern (the banks’ assets ranged from about $110 billion to $230 billion), but not large enough to require the highest levels of regulatory scrutiny.
While some acute economic conditions that created this latest banking crisis have subsided, not all economic stressors have been resolved. Recently, Moody’s warned of headwinds for regional banks, issuing grim outlooks for U.S. Bank and Fifth Third. The possible downgrades reignited concerns about the banking sector generally, and concerns about regional banks specifically – the type of banks that failed earlier in the year.
Are we out of the woods yet, or will we potentially see more regional bank failures?
The macro picture: plenty of risks remain
The common thread in this year’s bank failures has been the rise of interest rates to fight inflation. The Fed was arguably much too late in its rate actions to address inflation – it labeled a bout of inflation that had already risen above 4% as transitory, even though bouts of 4% inflation have rarely been short-lived. Acting late on inflation meant that the Fed had to restore its authority by steadily increasing rates through 2022 and into 2023, which inevitably led to a cratering of bond prices and inversion of the yield curve.
While most banks were capitalized well enough to withstand the unrealized losses on their books, some were predictably less prepared. Adding to the increasing unrealized losses were a slowing economy and more attractive cash rates offered in other products like money market funds. These factors decreased deposits and led to runs on SVB and Signature Bank, eventually precipitating the run at First Republic Bank.
Recent figures indicate this bout of inflation has crested, but we’re still significantly above the Fed’s 2% target threshold and returning to a benign level of inflation may take longer than anticipated. Even if moderate, persistent inflation means rates will need to remain elevated for longer, the yield curve will remain inverted for some time, and economic activity will be suppressed. Meanwhile, depositors will continue to rotate their cash holdings into better paying instruments, like money market or short-term bond funds. These conditions continue to put downward pressure on bank margins, as banks need to pay higher rates while still struggling with unrealized losses.
The market isn't anticipating a rate cut until at least 2024. Meanwhile, if inflation has an uptick (a greater possibility than many policymakers acknowledge), and rates must go higher, the impact on bond prices would lead to more stress at banks, particularly for regional banks that don’t have the scale or diverse balance sheets to withstand lower deposits. With an increased risk of defaults due to a slower economy, it’s clear that regional banks are still at risk.
The Fed has acknowledged its own missteps in this year’s bank failures, and there has been renewed interested in tightening the regulations that have loosened since the subprime crisis. But regulations take time to implement, and bank failures can happen quickly.
On the positive side, the liquidity programs in place at the time of this year’s crisis worked as designed. Larger contagion never spread to counterparties, and customers received their full deposits – even those that exceeded the insurance thresholds. The crisis ended as the economy outperformed, and an economic soft landing remains a possibility.
But a soft landing isn’t guaranteed. A range of outcomes remain possible, and investors may want to proceed cautiously in the banking sector, particularly regional banking stocks, at least until we see the yield curve normalize and margins expand.
