The unraveling of Silicon Valley Bank and the looming threat to regional banks
In the recent past, the banking sector has come under intense scrutiny, with regional banks bearing the brunt of the pressure. Last year, Silicon Valley Bank, a well-known regional bank, went through a serious crisis that led to its collapse. Currently, another regional bank, New York Community Bank, is on the brink of a similar fate. Doubts about the bank’s solvency led to a 45% drop in its share price in the space of two days. This situation highlights the current challenges regional banks are grappling with.
Understanding the banking system
To fully understand the issues facing regional banks, it is essential to understand how the banking system works. When you deposit money into a bank, the bank typically does one of three things with that money.
First, they can lend it out, offering mortgages to individuals to buy homes or to companies to build factories. Secondly, they can use part of the deposit to buy bonds. Finally, the rest is kept in cash.
For example, consider a bank with $100 worth of deposits. A typical asset mix for a bank might involve borrowing $85, using $5 to buy bonds, and holding $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 the profitability dilemma. They don’t want a large amount of cash because it’s not profitable. The money lent and the bonds purchased 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 your deposit in cash is enough to accommodate daily withdrawals. In comparison, the remaining 90% can be used to generate profits for the bank and its shareholders.
The problem of increasing withdrawals
The problem arises when banks face increased withdrawals. This could be because people are withdrawing money because their salary is not keeping up with inflation or because they want to take advantage of better opportunities elsewhere. When this happens, the amount of available cash decreases, forcing the bank to look for other sources to generate money.
Traditionally, banks sell their bonds to generate liquidity because the money they lend is illiquid. However, the current economic climate has complicated this strategy. The Federal Reserve raised interest rates at the fastest pace in 40 years. Since interest rates and bond prices have an inverse correlation, rising interest rates have led to falling bond prices. This means that banks cannot sell their bonds at the price they initially thought they were worth.
The impact of delinquencies in commercial real estate
Further exacerbating the banks’ difficulties is the increase in insolvencies in the commercial real estate sector. Almost all commercial properties have adjustable rate mortgages. Therefore, when the Federal Reserve raises interest rates, mortgage payments become more expensive.
Consider the case of an office building owner with an 85% occupancy rate in the post-COVID work-from-home world. With rents decreasing and mortgage payments increasing, the landlord finds himself in a difficult situation.
To mitigate the risk of bad loans, banks need to set aside more money for loan loss reserves. This is essentially bad debt insurance.
The pressure on the banks
Due to the Federal Reserve’s historic interest rate hikes, banks are under pressure. They are losing money on their deposits and bonds and have a lower quality loan portfolio.
In conclusion, regional banks are facing significant challenges. The collapse 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 critical for anyone involved in the financial industry.
Frequent questions
Q. What led to the collapse of Silicon Valley Bank?
Silicon Valley Bank encountered a significant crisis that led to its downfall. This is due to the intense scrutiny and pressure on the banking sector, especially regional banks.
Q. What are the three things a bank normally does with deposited money?
When money is deposited in a bank, the bank usually lends it out, uses some of it to buy bonds, or holds it in cash. Most of the money is usually lent or used to buy bonds, as these stocks generate profits.
Q. Why are banks facing the profitability dilemma?
Banks are facing a dilemma in terms of profitability because they do not want a large amount of money to remain in cash as it is not profitable. They prefer to allocate a larger 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 available cash begins to decrease, forcing the bank to look for other sources to generate money. This can be problematic, especially in the current economic climate where selling bonds, a traditional source of liquidity, is complicated by rising interest rates and falling bond prices.
Q. What impact does the increase in delinquencies in commercial real estate have on banks?
Increasing delinquencies in commercial real estate exacerbate banks’ problems. As mortgage payments become more expensive due to rising interest rates, banks must set aside more money for loan loss reserves, essentially insurance against bad debt.
Q. Why are regional banks under pressure?
Regional banks are under pressure from the Federal Reserve’s historic interest rate hikes. They are losing money on their deposits and bonds and have a lower quality loan portfolio. This situation is highlighted by the collapse of Silicon Valley Bank and the looming threat to New York Community Bank.
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