The unraveling of Silicon Valley Bank and the looming threat to regional banks
In the recent past, the banking industry has been subjected to intense scrutiny, with regional banks bearing the brunt of the pressure. Last year, Silicon Valley Bank, a notable regional bank, encountered a significant crisis that led to its downfall. Currently, another regional bank, New York Community Bank, is teetering on the brink of a similar fate. The bank’s solvency doubts have led to a 45% plunge in its stock price within a span of two days. This situation highlights the ongoing challenges that regional banks are grappling with.
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Understanding the banking system
To fully grasp the issues that regional banks face, it’s essential to understand the workings of the banking system. When you deposit money in a bank, the bank typically does one of three things with that money.
Firstly, they may lend it out, offering mortgages to individuals for home purchases or businesses for factory construction. Secondly, they may use a portion of the deposit to purchase bonds. Lastly, the remainder is kept in cash.
For instance, consider a bank with $100 worth of deposits. A typical asset mix for a bank might involve lending out $85, using $5 to buy bonds, and keeping $10 in cash. This implies that only 10% of the total deposit is kept in cash, which is used to pay people when they want to withdraw money from the bank.
The profitability dilemma
Banks are faced with a profitability dilemma. They don’t want a large amount of money sitting in cash because it’s not profitable. The money that’s loaned out and the bonds they buy generate profits. Therefore, they prefer to allocate a higher percentage of the money to these two categories.
In a typical economic environment, keeping 10% of the deposit in cash is sufficient to meet everyday withdrawals. In comparison, the remaining 90% can be used to generate profits for the bank and its shareholders.
The problem of increased withdrawals
The problem arises when banks face increased withdrawals. This could be due to people withdrawing money because their paycheck isn’t keeping up with inflation or because they want to take advantage of better opportunities elsewhere. When this happens, the amount of cash on hand decreases, forcing the bank to look at other sources to generate some money.
Traditionally, banks have sold their bonds to generate cash because the money loaned out is illiquid. However, the current economic climate has complicated this strategy. The Federal Reserve has increased interest rates at its fastest pace in 40 years. Since interest rates and bond prices have an inverse correlation, the increase in interest rates has led to a decrease in bond prices. This means that banks cannot sell their bonds for the price they initially thought they were worth.
The impact of delinquencies in commercial real estate
Further compounding the banks’ woes is increased commercial real estate business delinquencies. Almost all commercial real estate properties have adjustable-rate mortgages. Therefore, when the Federal Reserve increases interest rates, the mortgage payments become more expensive.
Consider the case of an office building owner with an occupancy rate of 85% in the post-COVID work-from-home world. With rents decreasing and mortgage payments increasing, the owner is in a difficult situation.
To mitigate the risk of bad loans, banks must set aside more money for loan loss reserves. This is essentially insurance against bad loans.
The pressure on banks
As a result of the Federal Reserve’s historic interest rate increases, banks are under pressure. They are losing money on their deposits and bonds, and they have a lower-quality book of loans.
In conclusion, regional banks are facing significant challenges. The downfall of Silicon Valley Bank and the looming threat to New York Community Bank are stark reminders of the problems plaguing the banking industry. Understanding these issues is crucial for anyone involved in the financial sector.
Frequently Asked Questions
Q. What led to the downfall of Silicon Valley Bank?
Silicon Valley Bank encountered a significant crisis that led to its downfall. This was due to intense scrutiny and pressure on the banking industry, particularly regional banks.
Q. What are the three things a bank typically does with deposited money?
When money is deposited in a bank, the bank typically lends it out, uses a portion to purchase bonds, or keeps it in cash. The majority of the money is usually lent out or used to buy bonds, as these actions generate profits.
Q. Why do banks face a profitability dilemma?
Banks face a profitability dilemma because they don’t want a large amount of money sitting in cash as it’s not profitable. They prefer to allocate a higher percentage of the money to lending and buying bonds, which generate profits.
Q. What problems arise when banks face increased withdrawals?
When banks face increased withdrawals, the amount of cash on hand starts to decrease, forcing the bank to look at other sources to generate cash. This can be problematic, especially in the current economic climate where selling bonds, a traditional source of cash, is complicated by increased interest rates and decreased bond prices.
Q. How does the increase in delinquencies in commercial real estate impact banks?
The increase in delinquencies in commercial real estate compounds the banks’ woes. As mortgage payments become more expensive due to increased interest rates, banks must set aside more money for loan loss reserves, essentially insurance against bad loans.
Q. Why are regional banks under pressure?
Regional banks are under pressure due to the Federal Reserve’s historic interest rate increases. They are losing money on their deposits and bonds, and they have a lower-quality book of loans. This situation is highlighted by the downfall of Silicon Valley Bank and the looming threat to New York Community Bank.
