Restoring depositor confidence in the banking industry is critical
The turbulence that has recently rocked the banking industry has caused worries for customers, investors and regulators, extending concerns globally across all economic sectors.
Grant Thornton banking industry leaders convened to discuss what caused the recent volatility and how it is affecting financial institutions and the economy. Here is a summary of their discussion.
Lack of liquidity and ineffective asset-liability management is a root cause. The recent events were caused by a liquidity shortfall, not a credit crisis. There is a lot of uncertainty in the current environment. First Silvergate Bank experienced a bank run in December and in early March decided to voluntarily liquidate. Following that was the bank run at Silicon Valley Bank (SIVB), as well as the closing of Signature Bank and the broader stock sell offs at many other institutions. The underlying problem is the rapid rise in interest rates over the past year, coupled with pandemic-era deposit growth, which had outpaced loan growth. This meant that banks were not able to proportionally deploy new deposits as loans. To put these funds to work, a number of banks resorted to purchasing lower-yielding, longer-term, fixed-rate bonds, which created an asset-liability duration mismatch and introduced interest rate risk when rates started to rise.
Some of the affected banks cater to startups and other corporate customers that generally hold larger uninsured deposits. When withdrawals started to accelerate, the banks were required to sell some of their underwater securities at steep losses. As rumors of capital erosion spread, the bank run at SIVB accelerated.
Burgeoning unrealized losses on securities holdings and their impact on bank capital. The FDIC has stated that as of year-end 2022, there were about $620 billion of unrealized losses on banks’ securities holdings. One aspect that is hotly debated now is the held-to-maturity investment category. Under current accounting standards, banks that have both the intent and ability to hold securities until maturity are not required to flow unrealized losses from interest rate movements through income or other comprehensive income, effectively not recording these unrealized losses. These unrealized losses are, however, required to be disclosed in the footnotes. Larger money-center banks are required to consider these unrealized losses in their regulatory capital calculation while smaller banks are not.
Instantaneous information is also a factor. Concerns over interest rate risk and asset-liability management, combined with information being transmitted instantaneously, created a perfect scenario for bank runs. Bank runs have been around for almost a century going back to the Great Depression. What is unique about the current environment is the speed at which and the amount that depositors tried to withdraw in a short period of time—and also the speed at which the bank regulators acted.
Under normal conditions, the FDIC typically goes in on a Friday after close of business along with either the State regulatory authority or the OCC to close down the bank after the lobby clears. But because there was a run and depositors withdrew their money in record amounts, the FDIC, in conjunction with the Federal Reserve and the State financial institutions division, closed the institution before the close of business. This is highly unusual, and it’s even more unusual for a bank to be put into receivership on a Sunday. This gives you a sense of the magnitude of this crisis and how quickly bank regulators have been acting.
Maintaining customer trust is critical in these situations. The big task in response to these events is to restore customers’ confidence in their banking relationships. In the immediate aftermath of the bank closures, a number of banks with potential asset-liability mismatches have seen their stock price drop significantly, which creates a natural concern among depositors. So, the question is, how do banks ensure that depositors have confidence that there won't be another run or another closure?
The actions of the Federal Reserve, the FDIC and the Treasury to reinforce that depositors would be protected is a big step, and so is the Federal Reserve providing emergency borrowing facilities to offer banks an alternative to selling securities with large unrealized losses, thus allowing them an easier way to deal with these problems. The industry is trying very hard to restore confidence and stability as we go through this period of uncertainty.
An effective hedging strategy is crucial. Banks should hedge their interest rate risk, especially in an inflationary environment.
The impact on future interest rate hikes. The events of the past week may cause a rethinking of future rate hikes by the regulators, which could make the fight against inflation more difficult. The Federal Reserve seemed to be planning to raise rates by another half a percentage point, but that may now change. While macroeconomic factors will continue to play a role, the safety and soundness of our banking system is at stake. Fortunately, it appears that inflation is slowly trending down which will help to ease the pressure on banks as well.
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