Aftershocks: Impact of the Banking Crisis

The current banking crisis rolled on with two key developments in late April. The first was the release of several reports from the Federal Reserve detailing the errors that led up to the collapse of Silicon Valley Bank in March 2023, blaming poor regulatory oversight combined with an absence of risk management for the failure.

The second was the slow demise of the California-based First Republic Bank, which specialized in service to high-net-worth individuals (those with deposits over $250,000, which are not covered by the Federal Deposit Insurance Corporation, or FDIC).  First Republic closed on May 1, 2023, and was taken over by JPMorgan Chase.

JPMorgan Chase, along with ten other banks, had deposited $30 billion to shore up the institution in March, but First Republic’s depositors had withdrawn over $100 billion by April. The bank’s plan to sell bonds and securities at a loss to raise capital caused its stock price to plummet and led to the FDIC saying it planned a takeover.

A Matter of Trust

While analysis shows U.S. banks to be solvent overall, the concern about banks has spread. The challenge in analyzing bank safety is that a severe loss of confidence can cause an otherwise functional financial institution to quickly come under duress. Although banking appears to be about numbers, it has at its base the concept of credit based on trust.

Consumer trust and confidence are especially important in the fractional-reserve banking system, in which banks that take deposits are required to hold a proportion of their deposit liabilities in liquid assets as a reserve and can lend the remainder to borrowers. This system, which has its roots in an era when gold and silver were traded, now shapes modern finance.

In fractional-reserve banking, only a part of each deposit is required to be available for withdrawal since depositors will rarely try to get all their money back at the same time. Fractional reserves expand the economy by freeing capital for lending. The dangerous weakness of fractional-reserve banking is that banks remain safe if nobody has a reason to panic. But if everyone panics and moves to withdraw deposits—a “run on the bank”—a bank can collapse. Even if it previously passed tests on issues such as capital adequacy, a bank collapse may occur unless the government steps in.

Look at the Window

A straightforward way to measure the stress in the U.S. banking system is the magnitude of bank support provided by the Fed via various methods. The most common method is the “discount window,” in which the Fed itself lends to depository institutions to provide ready access to funding and help manage liquidity risks efficiently while avoiding risky actions that have negative consequences, such as withdrawing credit during times of market stress. Banks have generally avoided using the discount window because the rate is higher than borrowing from other banks. However, it can provide emergency liquidity.

Following the collapse of Silicon Valley Bank, the Fed announced a new facility to help banks meet withdrawal requests from depositors and restore confidence: the Bank Term Funding Program (BTFP). The BTFP allows a bank to borrow an amount up to the face value of any government bonds held in the bank’s portfolio at a reasonable interest rate. The largest difference between the BTFP and the discount window is the collateral requirements; fewer types of collateral qualify for the new program. The maximum length of time for borrowing with the discount window is 90 days, while the BTFP allows up to one year.

With the seizure of Silicon Valley Bank and Signature Bank in March 2023, usage of the discount window and borrowing from the BTFP soared to levels not seen since the 2008 financial crisis. In April, however, the borrowing did begin to slow, showing that the recent financial-sector strains are beginning to ease.

Follow the Money

Cash continued flowing into government money market funds, confirming the pressure on depositors to leave the banking system. However, the pace of inflows into government money market funds has moderated since the apex of the banking crisis. This movement, known as “cash sorting,” reflects savers reaching for higher yields. Cash sorting started before the crisis began but seems likely to continue while short-term U.S. Treasury yields exceed the interest rates banks pay depositors.

Banks in several parts of the country tightened lending standards and raised concerns about liquidity and uncertain expectations for future growth. The Fed’s banking-sector contacts reported that lending behavior changed significantly in the wake of March 2023 failures. Banks are scrutinizing customers more and raising lending standards, leading to a decline in commercial and industrial loans in some regions. Some banks focused on lending to existing customers and became more prudent in lending to new customers.

Reducing Risk

The whole point of the Fed’s tightening monetary policy is to discourage lending and risk-taking. The Fed raises the cost of funding specifically to reduce or eliminate intermediates in the banking system and make lending more expensive. As funding becomes more expensive, lending slows. Deposits are typically the banks’ cheapest source of funding, and a reduction in deposits constrains lending.

Commercial bank lending dropped nearly $105 billion—the largest amount recorded by the Fed dating back to 1973—in the two weeks leading up to March 29. The $45 billion-plus decrease in the latest week reported was primarily due to a drop in loans by small banks. The pullback in total lending in the last half of March was broad and included fewer real estate loans, as well as commercial and industrial loans. The Fed’s report showed that by bank size, lending decreased $23.5 billion at the 25 largest domestically chartered banks in the last two weeks and plunged $73.6 billion at smaller commercial banks during the same period.

The biggest 25 domestic banks account for almost three-fifths of lending, although in some key areas—including commercial real estate—smaller banks are the most important providers of credit.

What’s Next?

Banks are still under some measure of stress: indices of bank stock and bond prices are still depressed. Deposit movements have hindered liquidity at some firms. This combination of circumstances typically causes more conservative lending. Additional conservatism on the part of banks will slow economic activity. The degree to which this occurs depends on how reliant borrowers are on banks.

In early April, the American Bankers Association index of credit conditions fell to the lowest level since the onset of the pandemic, which indicates that bank economists see credit conditions weakening over the next six months. As a result, banks are likely to become more cautious about extending credit. By mid-April, bank deposit outflows stopped, and deposits grew slightly after the large outflows in the previous weeks. Notably, the 25 largest banks, which include many midsize regional banks, gained more deposits than the smaller banks, a trend that probably should be expected.

Markets provide the lion’s share of financing in the United States; on that front, recent news has been considerably more encouraging. Indices of U.S. financial conditions have improved quite a bit in recent weeks, with credit spreads narrower and market volatility lower than their March extremes. Overall, access to capital is on the easier side of neutral.

Demand for commercial loans has been very modest, though. And the National Federation of Independent Business’ most recent survey, which was released mid-April, showed that 59% of firms were not looking for a loan; only 2% reported that their borrowing needs were not being satisfied.

Conclusion: Hazy Outlook

The bifurcation between bank and market pricing for credit makes it difficult to determine the consequences for economic growth in the United States. The focus has been on small businesses, which rarely access capital markets and get almost 70% of their credit from smaller banks.

According to the U.S. Bureau of Economic Analysis, smaller firms account for an estimated 25% of annual gross domestic product (GDP) and 35% of payroll employment. In addition, regional institutions provide most of the credit extended to commercial real estate. With challenges ahead for office properties, any reduction in bank lending will make a difficult situation worse.

Fed data suggests that money has been in motion ever since the Silicon Valley Bank failure. Since the beginning of March, money market fund balances are 9.5% higher; deposits at the 25 largest banks are 0.4% greater; and deposits at the remaining U.S. banks have dropped by 3.2%. To compensate for funding loss, smaller institutions have been among the more active users of the BTFP. This suggests that small and medium-sized enterprises will be the ones feeling a potential squeeze in the months ahead.

Considerable lags occur between the time when the Federal Reserve sets monetary policy and when banks’ lending policies change as a result. Even more time passes before lending stimulates or slows the economy. Central banks can only set policies; they can’t control bank behavior.

Investors have been taking big losses on commercial real estate debt, and that will continue. Everyone will have to learn all over again that you can lose money in real estate. But commercial real estate is unlikely to lead to the next big banking crisis. It’s just not big enough for the banking sector.

Regional and community banks will likely report disappointing earnings for at least the next year before things turn. There is a chance we will likely see a number of additional bank failures during this cycle. Commercial real estate debt may take down some of them. Other banks will be taken down by other factors. It’s a bank’s job to manage credit risk, interest-rate risk, and concentration risk, and those that don’t will get strung out.

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