In the wake of the 2008 crisis, the financial giants rescued from the brink were dubbed too big to fail, and policymakers and regulators focused on rules to make sure those banks ran more safely. Meanwhile, just out of view, a different problem was taking shape: What if some banks turned out to be too small to thrive?
“Small” is a relative term. The turmoil that’s recently gripped the industry has centered on banks often referred to as regionals—which, depending on whom you ask, covers institutions with $10 billion of assets all the way up to the likes of Silicon Valley Bank and First Republic, which each had about $200 billion in assets when they collapsed. That was enough to put them in the top 20 US banks but nowhere near the top four, where size is measured in trillions. JPMorgan Chase & Co. moved the needle only slightly on its almost $4 trillion in assets when it bought the remains of First Republic, taking it off the hands of the Federal Deposit Insurance Corp.
There was some hope that the shadow over regional banks might lift after the problem of First Republic was resolved. After all, both that bank and SVB had specific problems, most notably their high levels of uninsured deposits that customers were prone to yank the moment they had a reason to worry. But the market is still having trouble shaking its anxiety. The KBW Regional Banking Index is down 30% since the start of the year, and it’s off 9.5% since May 1, when JPMorgan stepped in.
That’s unsettling not only for the banks’ shareholders. Regional institutions are a key source of financing for small businesses, which employ about half of private-sector workers. If these banks are weak, it could make it even harder for these businesses to borrow money and potentially shift more power to bigger banks or force smaller ones to combine. People “underestimate what these banks mean for our financial ecosystem,” former FDIC Chairman Jelena McWilliams said in an interview with Bloomberg Television.
In hindsight it looks as if the low-interest-rate, high-stimulus pandemic economy was a trap for some unwary banks. For many businesses, having low rates and cash-rich consumers was like playing on an easy setting. But for bankers those conditions were tricky. All that government money being deployed to ease the pain of the pandemic needed somewhere to go, and a lot of it ended up in bank accounts. And because prevailing interest rates were so low, banks were under little pressure to reward customers with anything but the stingiest yields.
But there was a problem on the other side of the balance sheet: Low yields also made it harder for banks to earn money from lending or investing in securities. And demand for loans was anemic, as businesses and consumers were getting help from stimulus programs. So some banks chased growth through specialization. First Republic carved out a niche with wealthy customers, and SVB became a kind of financial concierge to the tech startup scene. When these banks looked to deploy the money they took in, they generally played it safe—or so they thought—buying government bonds or offering mortgages to wealthy customers with high credit scores. But these instruments had longer maturities and exposed the banks to interest-rate risk.
When prevailing interest rates go up, longer-dated assets paying lower rates become less valuable. Essentially, some banks had bet that rates wouldn’t go too much higher, too quickly—and SVB and First Republic, at least, got that wager dead wrong. In 2022 the US Federal Reserve pivoted to fighting inflation and started aggressively raising rates from near zero. By this May the central bank had brought the target on its benchmark rate above 5% for the first time since 2007.
The Fed’s hikes helped saddle banks with paper losses of $620 billion as of the end of 2022. If a bank can hold money-losing securities to maturity, which is typically the plan, the problem might remain hypothetical. But if depositors start withdrawing their money quickly, banks with too much interest-rate risk—known on Wall Street as duration—may face the prospect of having to sell those holdings at a loss, tipping them into insolvency. And this spring deposits came under pressure, as customers began to notice the losses some banks were exposed to—or just decided to move their money to higher-paying accounts elsewhere when yields rose. Banks that counted on the relationships they cultivated with their specialized clientele discovered loyalty was fleeting. “It’s like, Banking 101,” says Darius Palia, a Rutgers University finance professor. “Why didn’t bankers and regulators anticipate that they would be caught with this duration mismatch?”
The megabanks have so far steered clear of this pain. It’s partly that they’re more closely watched: The largest banks face more stringent rules and supervision. (Some of those rules would’ve applied to SVB and First Republic, too, if not for the partial rollback five years ago of the 2010 Dodd-Frank financial reforms.) Wall Street banks also tend to have a lot of capital to cushion losses, as well as economies of scale and more ways to move low-yielding assets off their balance sheet, such as securitization or asset sales. The bigger regionals may also be more resilient, says Joseph Mevorah, a senior managing director with Empire Valuation Consultants LLC.
But many smaller banks seem stuck in a grinding cycle of doubt and guarded optimism. Amar Reganti, a former US Treasury Department official and now a managing director at Wellington Management, likens it to a “slow-burning fire that sparks up every several weeks.” The sequence starts with a bank’s stock price diving: Speculation abounds, deposits remain relatively steady, and then things calm down until anxiety picks up again. “Almost what’s true or not becomes irrelevant to what the price action is,” Reganti says.
One way to lower the temperature would be for Congress to raise the $250,000 cap on deposit insurance. Although that’s plenty to cover the vast majority of individuals, many businesses maintain bigger balances for their operational expenses. And in the end, when SVB and New York’s Signature Bank failed on the same weekend, the government backed up all depositors. “The caps to me look like a human tailbone in a way,” a vestige of another time, says Robert Hockett, a professor at Cornell Law School.
Others say raising or getting rid of deposit caps could encourage riskier bank behavior. “Countries with more generous systems have more frequent banking crises,” and the severity of those runs are worse, says Patricia McCoy, a professor at Boston College Law School specializing in financial regulation. It’s better, she says, to focus on regulations that help keep banks out of trouble in the first place.
Larger capital buffers would help. Banks can accumulate capital in a number of ways including boosting profits (tough right now), cutting dividends or raising money from investors. Asking for more capital can be perceived as a distress flare, so it has to be done carefully, and it’s not a quick fix.
Another debate is whether the bank mess is the result of the Fed pushing too hard or just the ugly reality of how monetary tightening works. “A lot of what’s going on is exactly what you should have thought you were trying to do as a policymaker,” said Seth Carpenter, chief global economist for Morgan Stanley, during a recent panel hosted by the New York Fed. But he added a caution: “Is there an additional exogenous component? I think therein lies the real question of what could go wrong.” When banks are under stress, they may break in unpredictable ways.Read more: For Banks Under Stress, There’s a Federal Backstop That Provides Help Without Stigma
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