Bank Failures and the Fed

One could consider the Federal Reserve’s monetary tightening policy strategy as akin to the apologue of boiling a frog – or slowly turning up the heat until it’s too late. Last week, during his semiannual Humphrey-Hawkins testimony, FOMC Chair Jerome Powell turned up the heat by signaling that the Fed could once again increase its fed funds overnight benchmark rate by 50 basis points (bps), and this coincided with a run on Silicon Valley Bank (SVB).

SVB was a midsize bank with heavy exposure to tech startups, including a large concentration of deposit funding through institutional deposit accounts, and significant unrealized losses on a portfolio of government and agency mortgage-backed securities, which it was forced to realize as it sold assets to fund deposit outflows. Unrealized losses on SVB’s securities holdings were greater than its Common Equity Tier 1 capital, and depositors lost confidence in the bank’s ability to repay its $175 billion in deposits (as of 31 Dec. 2022), the vast majority of which were not covered by FDIC insurance. As a result, depositors withdrew $42 billion in deposits last Thursday and on Friday the bank was taken over by California state regulators, who appointed the FDIC (Federal Deposit Insurance Corporation) as receiver.

The failure of SVB has contributed to a broader sell-off in bank equity share prices, especially those of other U.S. regional banks. We have to imagine that deposit outflows across all the regional banks over the ensuing hours and days after the SVB failure were enough for decisive action from policymakers to try to stem the contagion over the weekend. On Sunday the U.S. Treasury, FDIC, and Federal Reserve jointly announced that the FDIC would guarantee the deposits of SVB and Signature Bank – a separate bank that was having similar issues – and that the Fed would set up a new bank lending facility with very favorable lending terms to give banks some additional time to shore up their balance sheets. The Fed agreed to lend money to banks collateralized by their high quality asset holdings marked at par (not the current market value).

To be sure, SVB was in many respects a unique bank. Other similar-sized regional banks do not have similar concentrations of uninsured institutional investor deposits, which has meant that their “deposit betas” – the increase in the interest rate that they are forced to pay on deposits as the Fed raises rates – have been lower. They also don’t have similar concentrations of unrealized losses in their securities portfolios relative to their Common Equity Tier 1 capital. As a result, if they are forced to sell securities to fund deposit outflows, they have larger capital buffers to weather any forced realization of losses. In addition, we view the large systemically important banks (U.S. SIBs) that must comply with the Dodd-Frank Act and are subject to regular liquidity and capital stress tests as financially sound and less vulnerable to a deposit run. In fact, several of the largest banks have been receiving net deposit inflows in recent days.