The US banking system is currently facing a significant challenge that is causing alarm bells to ring among experts and regulators alike. There is a convergence of twin crashes in the commercial real estate and bond markets, coupled with a massive amount of uninsured deposits worth around $9 trillion that can disappear quickly in the cyber age. According to Professor Amit Seru from Stanford University, who has co-authored a report on US bank insolvency with a group of banking experts from the Hoover Institution, almost half of the 4,800 banks in the country are potentially insolvent. They have already depleted their capital buffers and have negative equity. Even though some of these banks may not have to mark all their losses to market under US accounting rules, their balance sheets are still fragile, and they may need to take write-downs or find new capital, which could be challenging.
Despite the severity of the situation, the US Treasury and the Federal Reserve have downplayed the gravity and scope of the problem. They characterize the recent bank failures as "idiosyncratic" and confined to a few lenders that engaged in reckless lending and mismanagement and relied too much on uninsured depositors. Critics argue that this is a dangerous evasion that underestimates the systemic risk and contagion potential of a more widespread bank insolvency crisis, especially as the full impact of monetary tightening by the Fed has not yet been fully felt, and a large amount of debt is approaching a refinancing cliff-edge in the next six quarters.
The Hoover Institution report suggests that more than 2,315 US banks have assets that are lower than their liabilities, and the market value of their loan portfolios is $2 trillion lower than the book value. The vulnerable banks include not only small and medium-sized institutions but also some of the largest and most globally systemic banks in the country. The report warns that the banking system's solvency is at risk and that the Treasury and the FDIC (Federal Deposit Insurance Corporation) may not be able to contain the liquidity or solvency crisis by merely guaranteeing all deposits temporarily, as they did in the case of Silicon Valley Bank and Signature Bank, which collapsed in March, and whose uninsured depositors received a "systemic risk exemption" bailout.
The White House and the FDIC were initially reluctant to offer a blanket guarantee for all deposits, fearing that it would be perceived as a form of social welfare for the rich and could strain the FDIC's assets, which amount to only $127bn and are likely to shrink further. They hoped that depositors would infer an implicit guarantee and not withdraw their funds, but this gamble failed, as depositors fled First Republic Bank, despite an earlier infusion of $30bn from a group of big banks. The FDIC had to seize the bank, which wiped out shareholders and bondholders and cost $13bn in subsidies and $50bn in loans to entice JP Morgan to acquire it.
The First Republic Bank crisis may be a harbinger of a broader credit crunch, as many other small and medium-sized banks may reduce their lending and tighten their risk controls to avoid a similar fate. The PacWest bank, which is considered to be the next on the sick list, saw its share price fall by 11% in late trading on Monday, signaling the nervousness and uncertainty of investors and regulators.
The root cause of First Republic's downfall was its exposure to commercial real estate, which has been in the early stage of a deep slump and is expected to suffer a peak-to-trough decline of 22%, according to Capital Economics. This decline will further damage the loan portfolios of the regional banks that provide 70% of all commercial property financing. Another looming threat is the refinancing cliff-edge of the $4-5tn debt in the commercial property sector, which is mostly in the form of short-term loans that will come due in the next six quarters. If the commercial real estate market continues to decline, many borrowers may be unable to refinance their loans, leading to a surge in defaults and foreclosures. This, in turn, could trigger a chain reaction of bank failures and deepen the financial crisis.
Moreover, the US banking system is also exposed to risks in the bond market, as many banks have invested heavily in risky securities, such as collateralized loan obligations (CLOs) and leveraged loans, which are subject to rising default rates and falling prices. The market for CLOs, which are bundles of loans made to companies with low credit ratings, has grown rapidly in recent years, reaching a record $129 billion in issuance in 2018. However, the quality of these loans has deteriorated, and the default rate has risen from 1.2% in 2018 to 8.6% in 2020, according to Moody's.
As the US economy recovers from the pandemic and interest rates rise, the default rate is likely to increase further, putting pressure on the banks that hold these securities. In addition, the banks' exposure to leveraged loans, which are loans made to companies with high levels of debt, has also increased significantly, reaching $1.5 trillion in 2021, according to the Federal Reserve.
If these loans start to default, the banks could suffer significant losses and face a liquidity crisis, as investors may lose confidence in their ability to repay their debts. The banks may also face legal challenges from investors who claim that they were misled about the quality of these securities.
In conclusion, the US banking system is facing multiple challenges, including a potential crisis in commercial real estate, a surge in defaults in the bond market, and a large amount of uninsured deposits that could disappear quickly in the cyber age. While the Treasury and the Federal Reserve have downplayed the scope and gravity of the problem, many experts warn that almost half of the banks in the country are potentially insolvent and that the banking system's solvency is at risk. To avoid a financial crisis, policymakers need to take proactive measures to strengthen the banks' balance sheets, increase their capital buffers, and improve their risk management practices.
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