WEEK AHEAD

"When so many more products or services became digitized and connected, so many more things became "dual use." That is, technologies that can easily be converted from civilian tools to military weapons, or vice versa." – Thomas L. Friedman, New York Times Opinion Columnist, America, China and a Crisis of Trust, April 14, 2023

The Current Banking Fallout

First Republic Bank's shares have fallen sharply following disclosures that it suffered substantial deposit outflows in late March. CNBC, among others, reported that US bank regulators are considering downgrading their internal rating of the bank, the so-called CAMELS rating. The Fed's Bank Term Funding Program (BTFP) is only available to banks with CAMELS ratings of one to three (on a scale of one to five). The bank's current CAMELS rating is unknown because the ratings are not disclosed. However, a rating downgrade to four or lower would limit the bank's access to the BTFP, a development that has sparked credit concerns. Government officials have urged the bank to do something about its situation, by selling assets to other banks, for example.

When comparing the situation with SVB vs. FRC, SVB's unrealized losses on its held-to-maturity bonds were close to the number of its net assets. The Fed's vice chair for supervision told the Senate Banking Committee on March 28th that the bank lost more than 80% of its deposits in just two days, March 9-10. The outflows were quick, as 88% of SVB's deposits were uninsured by the FDIC, and before the Fed created the BTFP, the bank sold held-to-maturity bonds and realized losses in the process. Given the sharp decline in net assets, the government determined that the bank had effectively failed.
Changes in First Republic Bank's balance sheet usage between end-December and end-March show the bank secured cash using the Fed's new BTFP and existing discount window lending. Excluding the $30bn infusion of deposits from larger banks in March, outflows of deposits were substantial, with the number of uninsured deposits (excluding the larger banks' deposits) down 83% from end-December. The remaining amount of uninsured deposits is only $19.8bn. Cash and available-for-sale securities amount to $16.5bn, and held-to-maturity bonds to $31.4bn. The unrealized losses as of end-March for held-to-maturity bonds are not disclosed, but as of end-December, they were $4.76bn relative to a book value of the holdings of $28.3bn. The book value of held-to-maturity bonds has risen by $3bn, but given the decline in superlong yields, the unrealized losses as of end-March were not higher than in end-December. Based on net assets and unrealized losses on held-to-maturity bonds, the bank is unlikely to be insolvent, and net assets effectively are in sufficiently positive territory. The situation thus does not call for an immediate government bailout, and the thinking is that the US government would like private-sector banks to work out a solution involving an acquisition. Thus, the media reported that the government had no intention of bailing out the bank, which led to panic among market participants. Optimism is not warranted, but the thought here is the market is likely to be overreacting. Potential acquirers are stalling to get favorable terms. In a move to calm markets the week ahead, the FDIC stepped in over the weekend to attempt a distressed auction of First Republic. It was announced by this Monday morning JP Morgan is the winner.

Despite headline news touting a full-blown banking crisis, this is not a case of suddenly tightening in the face of an overheated market. The reason for the concern about commercial real estate loans following the failure of SVB is that 50% of the $5.6trn of commercial real estate loans outstanding as of end-2022 were by commercial banks and that 70% of this 50% were by banks other than the top twenty-five in terms of assets. However, delinquency and charge-off rates are at historical lows and lower at small and mid-sized banks. Nevertheless, banks have tightened their lending standards since last summer, a move better seen as helping to prevent a commercial real estate bubble. If banks tighten their standards further, the number of outstanding loans will likely decline this autumn, constraining the construction of non-residential and multi-family properties. However, housing demand will probably have picked up by then, helped by lower interest rates. What does pose a risk, however, is that 70% of commercial real estate loans are to partnerships and other noncorporate businesses and that US households have $17.0trn of equity in these businesses.

The current state of the banking crisis is showing signs of stabilization; the background to SVB's failure on March 10th had invested most of the deposits of its customers, most of whom were large businesses from the tech sector of the economy, in long-term securities. In doing so, it was taking on significant risk with liquidity and rising interest rates. Its failure was not the result of any weakness in the banking system or excessive lending that led to the accumulation of non-performing loans (Figure 13).

On March 12th, the US Treasury, the Fed, and the Federal Deposit Insurance Corporation announced that, by way of exception, they would guarantee all deposits at the failed bank, including uninsured amounts, while the Fed launched the Bank Term Funding Program (BTFP) that would allow banks with unrealized losses on their securities holdings and at risk of deposit outflows to borrow from the Fed for up to one year at par value of eligible securities such as US Treasuries and agency mortgage-backed securities in what was a swift and appropriate response (Figure 14). The crisis is being resolved, at least for the time being - Partly because of this, outflows of deposits from small and mid-sized banks, which reached a record level in the week to March 15th, stopped the following week, at least for the time being. Borrowing at the Fed's discount window, which reached a record level in the week of March 15th, also declined, with the outstanding amount halving in the week of March 29th (Figures 1 and 2). Lending by small and mid-sized banks, which was feared would be subject to tighter lending standards, has continued to grow, while the ratio of these banks' securities holdings to their deposits has held at just below 30% (Figure 3). The bank failure on March 10th has not proven to be a systemic risk.

Figure 1. Crisis background = outflow of deposits triggered by unrealized losses on Securities; settled for now. Figure 2. Dealing with unrealized losses and deposit outflow                                                                                               

Note: Collateral requirements at the discount window eased from March 12. For USD liquidity swap lines, the frequency of 7-day maturity operations increased from weekly to daily from March 20 through the end of April.

Figure 3. Deposits, loans, and security-deposit ratios at banks other than the top twenty-five by assets