THE WHYS OF RECENT U.S. BANK FAILURES

By Frank DiLeo GBU Life Investment Portfolio Manager

There’s a saying that, "being a banker is like being a pilot of an aircraft—it's years of boredom and seconds of terror." It seems that every few years, the often-quiet banking sector encounters troubles, either self-inflicted or from economic stresses that upend the business model. Between 2007 and 2008, banks experienced their greatest stress since the G reat Depression. With bank lending in the real estate sector at the forefront of the collapse, regulators took noted potential flaws in the overall banking model. Lending practices had become too lax, and reserve requirements were not monitored to the extent they needed to be given the exponential growth that had led up to collapse.

After 2008 the government put in place a series of protocols to oversee the banking sector and set new standards for capital requirements. Banks are required to “stress test” periodically to ensure that the worst-case scenario would not compromise the system's integrity. However, even with these regulations, 2023 still managed to bring headlines of multiple banks seeming to “fail.” Of the three largest bank failures in history, two occurred this year, despite these new regula tions. To understand why the sector remains challenged, we will dig into some pitfalls of the U.S. banking model and the potential risks they present to an individual investor.

Before we delve into why banks fail, we have to touch on two topics. The first is the “fractional banking system.” Regulators require that only a small portion of investor deposits to be available for customer wi thdrawals. The reasoning is that it is highly unlikely that a significant portion of customers will ask for a return on their deposits at the same time. The balance, after the fractional reserve is put aside, is invested in the markets as either incomegenerating assets on the books (i.e., bonds) or loans to clients of the bank.

The second topic is the “regional banking model” which is unique to the U.S. banking system. Most countries operate with a handful of “money center” banks, which are global and have a certain level of government oversight. The relatively small number allows for easier, more streamlined reviews. Missteps are often found quickly, and actions by governments can be implemented far more easily given how few pa rticipants exist. This scenario was proven this year, when the Swiss government swiftly orchestrated a merger of UBS Bank (UBS) and Credit Suisse (CS), when the latter incurred losses that caused it to almost collapse.

Currently, more than 4,800 banks operate in the US, usually in geographic regions. This model allows for banks in the US to cater to their clients better, focusing on the needs of the regi on and those customers they lend to. For example, banks in Texas tend to have more exposure to oil and gas, while banks on the West Coast have more exposure to technology and real estate. Although in theory the model works, it leaves many of these institutions uniquely susceptible to the ebbs and flows of the economies in which they operate. It is not uncommon to see a regional bank thrive, while one in a different region struggles. This factor, and the simple fact that so many more banks operate in the US, is why inevitably some will run into trouble over time.

The simple answer to why banks fail is insolvency. Essentially, their obligations to their depositors cannot be fulfilled with the assets the banks have on their books. The reasons that can happen are too many to list, but we c an focus on a few. In 2008, banks incurred steep losses from making loans to customers who could not fulfill their obligation to repay their loans. In a perfect storm of chaos, these loans were packaged and sold to other institutions, which took similar losses, creating a scramble for liquidity in multiple markets. Insurance companies and pension funds, which would otherwise rely on bank funding to fina nce their losses, had nowhere to turn.

Although the 2008 crisis is regarded as far more significant than the 2023 crisis, only one meaningful bank, Washington Mutual (WAMU), failed during that time. In 2008, WAMU lost $17 billion in investor deposits in nine days. Silicon Valley Bank (SVB), which failed in 2023, lost $42 billion in deposits in just four hours. The speed at which money can move with technol ogy is now a significant concern for regulators which want to stem the hemorrhaging outflows of troubled banks. In the case of SVB, the best solution was for the government to take over the bank and to freeze investor withdrawals so they could sort out the damage before the deposits were completely depleted. The recent troubles in the banking sector stem from a much different phenomenon and are magnified by technology and social media platforms that spread news in real time. Unlike the “bad loans” of 2008, the recent rate hikes by the Federal Reserve (Fed) Bank have greatly devalued ma ny of the investments that banks made in the years leading up to this rise. Many see this as an unintended consequence of the Fed tightening the economy to slow inflation. We often talk about “time value of money” and how the ability to borrow short and invest long is the driving principle for a bank to profit. What we are seeing now is that many banks have these long-dated “held-to-maturity” investments they own, losing significant value in a rising rate economy. Their depositors, who have caught wind of their unrealized losses, are quickly withdrawing their funds, fearing an inability to recover them, causing a proverbial “run for the nearest exits." Once confidence is lost in an institution, it becomes extremely difficult to "plug the hole." A bank losing deposits is akin to a ship taking on water. It will eventually sink under the weight of its creditors (depositors).

The Federal Deposit Insurance Corporation (FDIC) is the primary backstop for all U.S. banking deposits. The FDIC insures up to $250k of funds deposited in a bank. Although this insurance is explicit, the Treasury secretary has implicitly backstopped the deposits of all banks as a temporary measure to avoid further withdrawals at smaller, less capitalized institutions. The rhetoric implies that deposits of more than $250k will also have the support (not guarantee) of the U.S. government for the time being. As we mentioned previously, regulations have been put in place to monitor the “health” of banks in the US, and, for the most part, until recently, bank failures have been well contained. Banks are offered the support of the Federal Home Loan Bank (FHLB), often regarded as the “bank of banks.” Qualified financial institutions (including GBU Life) are offered the lending capacity of FHLB, which allows them to borrow cash in exchange for the assets they hold on their books. The government can make changes to the rules here, allowing these institutions to borrow mor e or less at higher or lower rates, as they see fit. Because of the recent concerns, FHLB has greatly relaxed lending requirements, allowing borrowing of 100% of the value of all government securities, although they are priced lower.

FHLB liquidity programs alone should make every bank in the U.S. temporarily solvent, as for all intents and purposes, the U.S. government is willing to loan unlimited fund s in the short term to cover withdrawals. What the government will do in the long term remains to be seen, but most analysts believe banks will be subject to more regulation and scrutiny going forward. Much like the 2008 financial crisis, lessons will be learned and built upon to ensure that the system functions properly.

The answer is, without question, yes. Even during the best eco nomic conditions, small regional banks have failed without any headlines. We mentioned that regional banks will always incur problems, whether lending to an industry that is struggling or to a demographic that is under economic pressure (e.g., employees in tech). The U.S. government has an excellent history of protecting depositor assets. Any breach of customer asset coverage would undermine the banking sector, and the government has proven that it will take any steps necessary to avoid that. The rules they put in place are working, as the contagion of bank problems seems contained to only a handful of smaller regional banks. In addition, we have seen several cases in which government assis tance prevented further contagion.

The current overall reserves in the banking system total about $55.5 billion, a staggering amount, and the case can be made that U.S. banks overall are better capitalized now than ever. As stated, aside from the reserves, FHLB continues to monitor lending, essentially backstopping most runs on withdrawals by providing liquidity to the system. In the worst-case scenario o f a failure, as in the cases we have seen recently, the government has multiple options to work with. The government can take over a bank as they did with SVB, eventually selling pieces to other banking institutions. They can also pair it up with a much more stable money center bank, as we saw with J.P. Morgan and First Republic Bank, before the problems become too dire. In either event, depositors are pr ioritized, and the banking industry will continue to move forward, likely with more government oversight and new regulations.

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Log into the GBU Life Member Community at community.gbu.org starting on Monday, July 17, 2023, at 8AM EST, to get the link to the game. Answer the trivia questions about travel facts. You have two minutes to answer as many questions as you can. The faster you answer, the more points you score! Keep an eye on the leaderboard until the end of the game on Thursday, August 3, 2023, at 4PM EST

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