‘Gradually, then Suddenly: How Banks Go Bust’

“How did you go bankrupt?” Bill asked.
“Two ways”, Mike said “Gradually, then suddenly”.

Ernest Hemmingway “The Sun Also Rises” (1926)

Part 1: Suddenly

Though we are yet to see an economic recession or a significant deterioration in the credit cycle, three banks, Silicon Valley and Signature in America, and Credit Suisse in Europe, have all just failed. These institutions suffered a collective loss of confidence not just from their investors but crucially from their depositors, who transferred their savings elsewhere, but on which the banks were reliant to fund loans and other investments. Since the banks could not liquidate their assets at a fast enough pace to meet customer withdrawals, they ran out of cash, and were suddenly declared bankrupt. 

What caused the 2023 banking crisis?

We need to start our explanation by returning to the extraordinary stimulus, following the outbreak of the COVID pandemic, which was largely not spent, but saved as bank deposits. In just two years, 2020-2021, the US banking system saw a $4.4trillion (+37%) surge in bank deposits (See Fig. 1: US Bank Liabilities), whereby deposit liabilities increased from just $14.5trillion in Q1 2020 to $19.9trillion in Q1 2022. Demand for credit in the real economy did not increase commensurately, meaning that over the same two years system bank loans increased by only $390bn (+3%), from $10.96 trillion to $11.35trillion (See Fig 2. US Bank Assets), leaving US banks with $4 trillion of excess deposits, which at the time cost them almost nothing, but still needed to be invested. The US banking system slowly began drowning in its own liquidity.

Fig. 1: US Bank Liabilities (since 1984)¹

Fig 2. US Bank Assets²

As part of the monetary stimulus, the Federal Reserve committed to forward guidance that interest rates would stay at near zero for the foreseeable future, with Chairman Powell stating in June 2020, that “we’re not even thinking about thinking about raising interest rates.”³ The logical and presumably intended consequence was that investors took more duration risk, including US commercial banks, which, in the absence of loan growth, increased their securities portfolio’s by 50% from $4.2trillion to $6.3trillion, 2000-2021, with $842bn (+128%) more Treasuries (holdings of longer duration US government bonds, increased from $658bn to $1.5trillion) and $1trillion (+40%) more Mortgage Backed Securities (mortgages that had been originated elsewhere but had now been repackaged and re-sold as collateralised securities, increased from $2.5trillion to $3.5trillion). (See Fig 3: US Bank Securities Portfolio). 

Fig 3: US Bank Securities Portfolio (since 2020)⁴

We should point out that investments in Treasuries ad Mortgage-Backed Securities were also encouraged by Basle III bank regulation, which focused on credit rather than duration risk, permitting banks to hold little or no capital as a buffer against potential losses. The recent political point scoring around the “deregulation” of smaller US banks is largely misplaced, unless it can be argued that this outcome of investing in low credit risk debt securities would have been specifically regulated against, by also forcing banks to hold more liquidity in ready cash, which would have made them significantly less profitable, and which in any case would likely never have specified a high enough weighting to prevent a depositor bank run. 

This increased capital allocation to securities portfolios also resulted in a lower yield on bank assets. Exposure toward higher yielding loans decreased from 54% to 47% of assets, and as a result the average yield on assets (which now included more lower yield Treasuries and Mortgage-Backed Securities) fell from 3.97% in Q12019 and 3.72% in Q42019 to a low of just 2.44% in Q1 2022 (See Fig 4. US Banks Net Interest Income). This was not a problem when the Fed Funds rate was just 25bps, since the cost of deposits also fell from an average of 1.01% to just 0.22% over the same period, but this would sow the seeds of the next banking crisis as the Federal Reserve began raising its key interest rate from near zero, which would see upward pressure on deposit liabilities, but the yield on longer duration assets, including securities portfolios, was now largely locked-in.

Fig 4: US Banks Net Interest Income (since 2019)⁵

Mark-to-market losses of securities

Regulators allow banks to mask the inherent volatility in their business models by recognising credit losses over an economic cycle and not marking-to-market the prices of interest rate sensitive debt securities they intend not to trade, but to hold to maturity, which unless the asset defaults, will be redeemed at par. This has logic since losses on a debt security reflecting only higher interest rates reflects only the lost opportunity cost of being unable to reinvest the capital used to purchase that security at higher prevailing rates of interest.

From the summer of 2020, which marked an all-time low, US interest rates rose across every duration, with the yield on the 10-year benchmark Treasury increasing from just 0.52% in August 2020 to its most recent peak of 4.23% in October 2022. This resulted in billions of dollars of mark-to-market losses for banks holding government and mortgage bond securities. Banks got around this problem with an accounting reclassification. Between Q1 2020 and Q4 2022, “available for sale” securities decreased from $3.24 trillion to $3.07 trillion, whilst “held to maturity” securities increased from $950 billion to $2.8trillion (See Fig 5: US Bank Accounting Classification of Securities), meaning that unless banks were forced to sell before maturity, no recognition of loss on over $1 trillion of securities recategorized was now required. 

Fig 5: US Bank Accounting Classification of Securities (since 2020)⁶

Holding to maturity is, however, dependent on a bank’s ability to continue to fund the asset, which is reliant on the confidence of its creditors, including its depositors, that the bank is solvent. On March 1st, Silicon Valley Bank released its 10-K disclosure to the SEC, which revealed $15.2bn of unrealised losses on its held-to-maturity securities portfolio. This compared with just $11.8bn of tangible shareholder equity. In other words, the 16th biggest bank in the United States was already technically insolvent. On March 8th, the bank announced that it had sold $21bn of previously designated held-to-maturity securities to raise liquidity, but in doing so would be forced to recognise a $1.8bn loss to shareholders. Since by now investors realised there was also another $13bn of further unrealised losses, the proposed $2.25bn new equity raise failed. The next day as its share price fell 60% there was a run on the bank which threatened to wipe out its entire deposit base. On Friday 10th March, the FDIC announced that the bank had failed.⁷ 

Liquidity Risk

Banks are vulnerable to liquidity risk since they are predominantly funded by short-term liabilities (demand deposits) to make (or purchase) loans (assets) which are longer term, hence there is always duration risk that cannot be fully hedged away. This makes bank balance sheets inherently unstable, particularly considering the typical equity gearing (the US banking system currently has $2.2 trillion of equity capital funding $23.6 trillion of assets. (See Fig 1. & 2.)) which is necessary to magnify a modest return on assets into a respectable return on equity.

Banks can only generate a return on capital if only a fractional amount of their liabilities are held as assets in cash at any time to satisfy withdrawals. This principle of “fractional banking” relies on depositor confidence that other depositors will not demand their cash back at the same time, leaving the depositor who was late joining the run stuck in a bank that is forced to close its doors to further withdrawals. If enough depositors decide collectively to withdraw more cash than the bank has in its vaults, then the bank will have to repo or pawn eligible assets with the central bank for additional liquidity, or if that is not sufficient liquidate enough assets fast enough to meet deposit withdrawals. Once started, bank runs are difficult to stop because of the panic created and the potential for the fire-sale of assets to meet liquidity to realise losses that wouldn’t necessarily occur without the urgent need for cash.

Following Walter Bagehot’s dictum, that in a financial crisis, central banks, as “lender of last resort”, should lend freely, against good collateral, at a penalty rate, on Sunday March 12th, the same evening as New York regulators declared the failure of Signature bank, the Federal Reserve announced a new “Bank Term Funding Program” (BTFP) that allowed banks to pawn their assets at their purchase price, rather than market price via the terms of the previously prevailing repo regime using the Fed Discount Window (See Fig. 6 Bank borrowing from the Federal Reserve). This should mean that few banks will now fail because of the absence of liquidity. However, since the cost of this cash comes at the key central bank interest rate (5%), which is significantly above the interest rate passed on to savers on their deposits (1.3%), this repo source of funding gradually becomes ruinously expensive for banks, meaning that they now risk going bust not suddenly but gradually. 

Fig 6. Bank borrowing from the Federal Reserve⁸

Barry Norris
Argonaut Capital
April 2023