The Investment Scientist

The Systemic Crisis with Banks: How Bad Will It Get?

Posted on: March 16, 2023

In this article, I will not discuss the Credit Suisse collapse and rescue that just happened less than ten hours ago, since I don’t understand the Swiss banking system as well as I understand the US system. Here in the United States, we have had a rapid succession of specialty bank collapses: Silvergate Bank, Silicon Valley Bank (SVB) and Signature Bank. Most of their depositors are super wealthy people or businesses whose deposits amount to much more than the 250k guaranteed by the FDIC. The majority of American banks do not have that kind of customer profile and the majority of American depositors have less than $250k in their bank accounts. Does that make the rest of the banks in America safe? I am afraid not. 

Though the depositor profiles may be different, all banks invest in the same “safe” government or government-backed debt securities, and all banks have unrecognized losses in those securities. By some estimates, the entire US banking system has $660B in unrecognized losses. 

Note that these securities are deemed safe since if one holds them to maturity, one will get the principle back for sure. But because of the year-long rally of long-term interest rates, the value of these securities is much lower than their face value now. This begs the question: why didn’t anyone expect this rally of long-term interest rates? Not even the smartest people in the banking industry predicted it, even though everybody knew that the Fed would raise interest rates.

Alas, the only interest rate the Fed can raise is the very short-term interest rate. Usually, when short-term rates go up, inflation slows, and long-term rates come down. If that had happened, banks would be in good shape. But this time, despite the Fed repeatedly raising short-term rates, long-term rates have stubbornly kept going up. What gives? I’d like to argue that  there are a few reasons (that won’t go away easily.)

  1. The Fed has lost a great deal of its credibility when it comes to fighting inflation. It lost it when it announced unlimited money printing to support the market in March of 2020, and when it kept telling people inflation was not a concern at the end of 2021. 
  2. The usual foreign buyers (China, Japan, and Saudi) of US government bonds have not only stopped buying them, they actually are dumping them in large quantities. One possible reason is geopolitical rivalry, another may be concerns about the sustainability of US budget deficits. 
  3. The Fed, currently in the thick of its fight to tame inflation and restore its credibility, can not just print money to buy these bonds anymore. 

President Biden’s new budget has a deficit of  $2T, meaning the federal government needs to sell $2T in bonds. Looking around the world, however, there are no longer major buyers. Thus the price of bonds has to come down, and yields go up, leading to so much in unrecognized losses among banks’ assets and shaking the foundation of the banking industry.

Now, smart depositors are fleeing smaller and regional banks to larger banks, money market funds in brokerages or even directly to Treasury Direct. There, they feel their deposits are much safer. This is a slow exodus that could gather pace, which could lead to a slow-motion collapse of some regional banks. I will not write about the pros and cons of larger banks vs money market funds vs Treasury Direct but you can always schedule a 2nd Opinion Review with me to discuss these options. 

Schedule a 2nd opinion financial review, buy my wealth mgmt books on Amazon.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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