Silicon Valley Bank, Signature Bank, Credit Suisse, First Republic, and now Deutsche Bank; the list grows longer and soon it will be too bothersome to list them all.
Right now the focus is on the individual banks and things they did or didn’t do. Also, there is the tendency to affix blame and causation to risky loans and bad banking strategy. However, the problem extends beyond the walls of any individual bank or the boundaries of any particular country.
Analysis provided and explanations given by the Federal Reserve, banking officials, and the United States Treasury don’t do justice to the gravity of the situation. Those in charge seem to know that.
THE FSOC – SPECIAL MEETING
This past Friday, Treasury Secretary Janet Yellen presided over a meeting of the Financial Stability Oversight Council (FSOC).
Treasury Secretary Yellen is the designated FSOC chair. The FSOC also includes, among others, the respective chairs for the following organizations: Federal Reserve, Securities Exchange Commission, Federal Deposit Insurance Corporation, and the Commodity Futures Trading Commission.
The purpose of the FSOC is to “identify and monitor excessive risks to the U.S. financial system…”. Presumably this would apply to recent revelations of questionable lending practices undertaken by some of the banks currently under receivership.
It is hard to say what to expect from this meeting. Just the fact that it comes so closely on the heels of the announced solutions to SVB and Signature Bank problems seems to imply serious concern on a grander scale.
SYSTEM-WIDE PROBLEM – TWO ISSUES
What has happened thus far cannot be ascribed to actions by individuals, bank officers, lending practices or financial miscues. What has happened to SVB and others is happening to other banks. ANY bank is vulnerable and there will be more bank names in the news.
There are two reasons for the problem: 1) rising interest rates and fractional-reserve banking.
The reality of rising rates bites if you are an existing bond holder. Most banks hold sizable bond positions in their portfolios. The preferred choice is U.S. Treasury bonds, but certain government agencies and mortgage backed securities are also included.
As interest rates rise, the value of existing bonds declines. Over the past two years, all bond prices have dropped. This includes U.S. Treasury bonds and mortgage-backed securities, the primary holdings of banks.
The size of the loss varies depending on the maturity of the bond. Longer-dated bonds have larger losses.
An existing U.S. Treasury bond with a 20-year maturity has lost more than one-third of its value over the course of time that rates have been rising. Certain longer-dated bonds lost almost 40 percent of their value during calendar year 2022 alone.
All banks operate under a system known as fractional-reserve banking. Currently, banks are required by the Federal Reserve to maintain reserves of only ten percent of deposits on hand. The rest can be lent out.
In order to satisfy withdrawal demands of its depositors, Silicon Valley Bank was forced to liquidate assets that were held in U.S. Treasury bonds and mortgage-backed securities. Those bonds were sold at a significant loss due to the decline in existing bond prices associated with the trend of higher interest rates over the past two years.
WHY IS THE FED RAISING RATES?
The Federal Reserve’s stated intention for raising interest rates is to get inflation under control. The problem is that the U.S. and world economies function and depend on credit.
That cheap and easy credit was fostered and promoted by the Federal Reserve by driving interest rates down to abnormally low levels over forty years. Now the Fed is making credit more costly and restrictive by raising interest rates.
Whatever their intentions, the Federal Reserve is dealing with effects of problems which it created. And there is not much they can do to stem the tide of blowback from the system they created.
- The list of “problem” banks is growing larger and will continue to grow. Any bank at any time is a potential candidate for negative publicity and bankruptcy.
- Causes of No. 1 above are rising interest rates and fractional-reserve banking.
- The underlying problems are system-wide.
- The fragile nature of the banking system is global in nature.
- Things will get worse (a lot worse) before they get better.
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Today’s post guest written for Neptune by Kelsey Williams.