Blog: How Many Banks Are at Risk of Insolvency Right Now? – ProMarket

Given the recent banking turmoil and failure of SVB and Signature and issues in First Republic, it is important to understand the risk to the rest of the banking system in the U.S. Seru, Jiang, Matvos and Piskorski calculate the risk of further bank failures if uninsured depositors withdraw their funds, and recommend policy changes to address this risk.

Tightening monetary policy by central banks can result in substantial negative effects on the worth of long-term assets such as government bonds and mortgages. This can lead to losses for banks that practice maturity transformation – financing long-term assets through short-term liabilities like deposits: As interest rates increase, the value of a bank’s assets may decrease, which can ultimately lead to bank failure through two interrelated pathways.

Firstly, if the bank’s liabilities surpass the value of its assets, it may become insolvent, particularly for banks that need to increase deposit rates during interest rate hikes. In fact, during the 1980s and 1990s, nearly one-third of savings and loan institutions failed due to losses incurred from long-term fixed-rate mortgages that declined in value when interest rates surged. This resulted in a substantial reduction in the net worth of the S&L industry.

Secondly, uninsured depositors may become apprehensive about potential losses and withdraw their funds, triggering a bank run. Uninsured depositors constitute a substantial funding source for commercial banks, making up roughly $9 trillion of their liabilities, which exposes these institutions to a significant risk of bank runs. Recently, the largest bank failure since the great recession happened on March 10, 2023, when Silicon Valley Bank (SVB) was placed under FDIC receivership. With 92.5% of its deposits uninsured, there were significant withdrawals that ultimately led to the bank’s collapse in just two days.

How much of an outlier was Silicon Valley Bank? In a recent paper, we stress test the financial stability of the US banking system by analyzing U.S. banks’ asset exposure to a recent rise in the interest rates.

Stress Testing the Banking System

The starting point of our analysis is noting that the Federal Reserve Bank’s monetary policy tightening caused significant value declines in long-duration assets. Between March 7, 2022, and March 6, 2023, the federal funds rate rose steeply from 0.08% to 4.57%, accompanied by quantitative tightening. Consequently, long-dated assets like those found on bank balance sheets experienced significant declines in value during this period.

For instance, the SPDR Portfolio Mortgage-Backed Bond ETF (SPMB), which tracks the market value of residential mortgages, decreased by more than 10% from 2022:Q1 to 2023:Q1. Similarly, the iShares CMBS ETF showed that the market value of commercial mortgages declined by more than 10% during this time. Long maturity treasury bonds were particularly affected by the tightening of monetary policy, with 10-20 year and 20+ year Treasury bonds losing approximately 25% and 30% of their market value, respectively, as suggested by the iShares Treasury ETF.

In order to evaluate the financial stability of U.S. banks, we utilize bank call report data that captures the composition of assets and liabilities for all 4,800+ U.S. institutions, along with market prices of long-term assets. Our analysis is conducted in multiple stages. Firstly, we examine losses on banks’ assets including their loan portfolios held to maturity, which have not been marked-to-market, as well as securities linked to real estate (such as mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS)), US Treasuries, and other asset-backed securities (ABS)). These assets comprise more than half of bank assets (72% of $24 trillion dollars).

Adjusting these assets to their market values, our findings indicate that bank assets decline on average by 10%, with the bottom 5th percentile experiencing a decline of approximately 20%. That means the market value of U.S. banking system assets is $2.2 trillion lower than suggested by their book value if they were forced to sell the assets. Interestingly, SVB does not stand out as much in the distribution of marked-to-market losses, with about 10% of banks experiencing worse marked-to-market losses on their portfolio.

Bank Solvency

Next, we analyze how this decline in assets impacts the solvency and run incentives of banks. We begin by assessing banks’ funding structures before the recent monetary tightening. While SVB was reasonably well-capitalized from a capital perspective, with 10% of banks having less capital than SVB, its use of uninsured deposits stood out. It ranked in the 1st percentile of the distribution in uninsured leverage, suggesting that over 78% of its assets were funded by uninsured deposits.

In other words, SVB’s bank liabilities were more prone to runs than those of other banks. Therefore, it is crucial to examine uninsured leverage (i.e., Uninsured Debt/Assets) to determine whether these losses could result in other U.S. banks becoming insolvent. Unlike insured depositors, uninsured depositors risk losing a portion of their deposits in the event of bank failure, which could incentivize them to initiate a bank run when bank’s asset values are depressed.

We compute similar incentives for the sample of all U.S. banks. Even if only half of uninsured depositors decide to withdraw, almost 190 banks with assets of $300 billion are at a potential risk of impairment, meaning that the mark-to-market value of their remaining assets after these withdrawals will be insufficient to repay all insured deposits. Alternatively, if we anchor around 30% of uninsured depositors running – similar to what occurred in SBV before FDIC stepped in – around 150 banks would be at risk. We consider many other conservative scenarios and find a substantial number of banks at risk even if a small proportion of uninsured depositors left a bank. Moreover, if uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk. Overall, these calculations suggest that recent declines in bank asset values significantly increased the fragility of the US banking system to uninsured depositor runs.

Addressing Systemic Risk

There are several medium-run regulatory responses one can consider to an uninsured deposit crisis. One is to expand even more complex banking regulation on how banks account for mark-to-market losses. However, such rules and regulation, implemented by myriad of regulators with overlapping jurisdictions might not address the core issue at hand consistently (Agarwal et al. 2014).

Alternatively, banks could face stricter capital requirement that would decrease their reliance on subsidized funding and increase their skin in the game. Such a move would bring the capital ratios of banks closer to less regulated lenders, who have capital ratios nearly double that of banks. Discussions of this nature remind us of the heated debate that occurred after the 2007 financial crisis, which many might argue did not result in sufficient progress on bank capital requirements (see Admati et al. 2013, 2014 and 2018).

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