The banking industry is a cornerstone of the global economy, facilitating the flow of capital and supporting businesses and individuals with their financial needs. However, the industry is not immune to challenges, and bank failures can cause significant disruptions in financial markets. In recent times, there have been reports of bank failures and acquisitions, raising concerns about the stability of the banking industry.
Let us explore the recent bank failures, the reasons behind them, and the impact they may have on the banking industry and the wider economy. Although not widespread, there are many banks that have made poor decisions with how they have invested their funds. The deposits they receive from their bank customers are the funds being invested, and many banks have invested in longer-term investments, such as treasuries. In the past year, the Federal Reserve has aggressively raised rates, causing the value of the treasuries held by banks to reduce.
Which Bank Failures Happened This Week?
The stability of the banking industry has come under scrutiny recently with the failure of First Republic Bank. It was the second-largest bank failure in the country, and instead of a federal bailout, JP Morgan Chase took over its assets. This deal makes Chase an even bigger bank than it already was. The situation has led to questions about the stability of the banking industry, especially as it marks the third bank failure in two months.
On April 13, 2023, the California Department of Financial Protection and Innovation closed First Republic Bank, San Francisco, California, due to financial instability. The Federal Deposit Insurance Corporation (FDIC) was appointed as the receiver, and to protect depositors, it entered into a purchase and assumption agreement with JPMorgan Chase Bank, National Association, Columbus, Ohio, to assume all of the deposits and most of the assets of First Republic Bank.
Acquisition of Deposits and Assets
JPMorgan Chase Bank, National Association, submitted a bid for all of the deposits of First Republic Bank and agreed to purchase most of its assets. As a result, all depositors of First Republic Bank became depositors of JPMorgan Chase Bank, National Association, with full access to all their deposits. The FDIC insured the deposits, and customers did not need to change their banking relationship to retain their deposit insurance coverage up to applicable limits.
Branches and Systems Changes
As part of the agreement, First Republic Bank’s 84 offices in eight states reopened as branches of JPMorgan Chase Bank, National Association, during normal business hours. Customers of First Republic Bank were advised to continue using their existing branch until they received notice from JPMorgan Chase Bank, National Association, that it had completed systems changes to allow other JPMorgan Chase Bank, National Association, branches to process their accounts as well.
JPMorgan Chase Bank, National Association, also entered into a loss-share transaction with the FDIC on single family, residential, and commercial loans it purchased from First Republic Bank. Under the agreement, the FDIC and JPMorgan Chase Bank, National Association, will share in the losses and potential recoveries on the loans covered by the loss-share agreement. The transaction is expected to maximize recoveries on the assets by keeping them in the private sector and minimize disruptions for loan customers.
Qualified Financial Contracts
JPMorgan Chase Bank, National Association, will also assume all Qualified Financial Contracts of First Republic Bank, which include derivatives and repurchase agreements.
The resolution of First Republic Bank involved a highly competitive bidding process and resulted in a transaction consistent with the least-cost requirements of the Federal Deposit Insurance Act. The FDIC estimated that the cost to the Deposit Insurance Fund would be about $13 billion. However, the final cost will be determined when the FDIC terminates the receivership.
Potential Reasons for the Banking Failures
Although not widespread, there are many banks that have made poor decisions with how they have invested their funds. The deposits they receive from their bank customers are the funds being invested, and many banks have invested in longer-term investments, such as treasuries. In the past year, the Federal Reserve has aggressively raised rates, causing the value of the treasuries held by banks to reduce.
Several reasons have been identified for the banking turmoil:
- Large Deposits: Many of the banks under pressure have a large number of deposits that are too big to be insured by the Federal Deposit Insurance Corporation (FDIC). This makes them vulnerable to a run, where customers scramble for their money back, and a bank would be unable to deal with that demand.
- Investments in Government Bonds: Investments made by investment banks in government bonds have lost value as the Federal Reserve has raised interest rates aggressively. This has led to a significant reduction in the value of these investments.
- Exposure to Commercial Mortgages: Many lenders are exposed to commercial mortgages, which are becoming increasingly risky as the economy slows down. These mortgages are often made to businesses that are unable to repay their loans in a timely manner, resulting in higher levels of defaults and foreclosures.
Duration Problem with Balance Sheet Assets
The bank can hold these securities to maturity and receive the invested funds back. The problem comes up if the bank is short on covering customer deposits and must sell these investments. In doing so, the bank may take significant losses on these investments. Therefore, banks have a duration problem with their balance sheet on how they hold assets.
Banks that have been better managing their assets will be in a solid position, which may be the case when it comes to smaller community banks. These banks may be more invested in their local communities, which may be more sustainable. However, unfounded fears have led bank customers to move their deposits to the few megabanks, believing that they are safer as they are too big to fail. This reaction could have some negative consequences in smaller communities.
Tightening Credit and Economic Slowdown
The bank failures also create additional credit-tightening consequences. As the Federal Reserve continues to tighten, they create more strain on the banking sector. Perhaps it may be time for the Fed to pause on its aggressive tightening with its rate increases as it is beginning to impact many segments of the economy.
This past Wednesday, the Fed increased its overnight lending rates by another .25%. With the latest bank failure, this may be a strong signal that the Fed should pause on any future increases. The cumulative effect of the rate hikes over the past year will continue to slow the economy, bringing the current inflation rate lower.
No Further Contagion Amongst Regional Banks
These bank failures have little in common with what happened in the 2008 housing crisis. With these recent bank events, the hope is that there is no further contagion amongst regional banks. Fed Chairman Jerome Powell did state that the banking sector remains strong. However, new signs of banking turmoil have emerged following the failure of First Republic Bank.
The third bank failure in 2023 has raised concerns about the stability of other regional banks. Shares of several regional banks, including California-based PacWest and Western Alliance, have been hit hard, fueling fears of more bank failures. The situation has been worsened by Wall Street investors who are betting on a further decline in regional bank shares.
The current situation in the banking industry is uncertain, and the future remains unclear. While some regional banks may struggle in the short term, others are expected to remain stable. Smaller community banks, in particular, may be better positioned to weather the storm, as they are more invested in their local communities and have a more personal relationship with their customers.
In conclusion, the banking industry is currently facing a period of turmoil, with several bank failures and increasing concerns about the stability of the industry. However, it is important to note that not all banks are created equal, and some may be better positioned to weather the storm than others. Additionally, there are steps that can be taken to improve the stability of the industry, such as reducing the reliance on large deposits and investing in less risky assets.