Finance  ·  Analysis

No End in Sight: Why the Regional Banking Crisis Will Continue

Large uninsured deposit bases and fragile equity valuations create risky cycle for banks

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Some regional banks continue to face possible extinction nearly two months after the 2023 banking crisis began with the sudden collapse of Silicon Valley Bank (SVB) on March 10. Economists now believe that the combination of large uninsured deposit bases and the fragile relationship between bank equity valuations and consumer confidence could turn an ongoing liquidity crisis into a long-term problem for federal regulators.

The KBW Nasdaq Regional Bank Index — which measures the performance of publicly traded U.S. banks — reached its lowest level in three years on May 4, and is down nearly 30 percent on the year. But certain regional banks, specifically those headquartered in Western states, are experiencing such consistent external pressures from stock market stress that economists fear wavering investor behavior could spark immediate flights from spooked depositors. 

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“Normally, they’re not particularly correlated, as there are many reasons why stock prices go up or down, and changes in earnings expectations don’t normally create liquidity issues for banks,” said Terrence Belton, adjunct professor of finance at Chicago Booth School of Business. “Obviously, in extreme circumstances like we’re in now, there’s clearly a feedback loop.”   

PacWest Bancorp of Los Angeles saw its stock fall from nearly $30 a share in early February to $3 per share last week, leading the bank to confirm a Washington Post report that it is exploring strategic options that include a potential sale. Despite holding $40 billion in assets under management and experiencing no unusual deposit flows since the start of the crisis, the bank’s stock price is down 73 percent since Jan. 1. 

Western Alliance Bancorporation of Phoenix, holding $67 billion worth of assets under management, watched its stock plunge to $18 per share last week. The bank now carries an equity value roughly 51 percent less than its price at the start of the year. Bank officials have categorically denied a Financial Times report from last week that it is exploring a sale.    

Other regional banks with even greater assets under management, such as First Horizon Bank of Memphis ($88 billion AUM in 2022) and Zions Bancorporation of Salt Lake City ($90 billion AUM in 2022), are experiencing yearly stock-price declines of 55 percent and 48 percent, respectively, further straining a tenuous and interconnected national financial system.  

“When declines in stock prices are that significant, they become self-fulfilling prophecies and cause depositor runs and liquidity issues that could put a bank down,” Belton explained. “That’s clearly at work today.”

The threat posed by short sellers — investors who bet against bank stocks’ future price increases — has captured the attention of the Biden administration. Last week Reuters reported that federal and state officials are monitoring whether “market manipulation” has caused the shares of multiple regional bank stocks to fall. The White House and Securities and Exchange Commission are now studying short-selling pressures, according to reports. 

On May 4 alone, short sellers made nearly $400 million in paper profits from bets placed against regional banks, according to Ortex, a data analytics firm. 

“It’s not clear to me that short sellers are really in control. Short selling is incredibly expensive and risky,” said Steven Kelly, senior research associate at Yale Program on Financial Stability. “If they decided to attack a bank that was fundamentally sound and viable – like JP Morgan Chase or Morgan Stanely – then they just wouldn’t win. Those banks can raise new equity, get new investors, and [the short sellers] would be up against a wall of money they couldn’t beat. 

“But there’s sort of a justification to sell these regional West Coast banks that relied on this business model that is now under pressure,” he added.  

The business model at the core of the regional banking crisis is not too different from traditional banking theory: borrow short, lend long. But this fundamental theory — or even law — of responsible asset management has created an “inherent instability” in the banking system, according to Christopher Thornberg, founding partner of Beacon Economics, especially once the Federal Reserve raised its benchmark federal funds rate 10 times in 14 months (after keeping interest rates between zero and 2 percent for much of the past 15 years). 

“They did what banks should have done: They bought a whole bunch of debt securities at low interest rates,” Thornberg said. “None of these banks have a problem with their lending base. They’ve made good loans. They’re not seeing losses because they made bad loans, and that’s what’s so infuriating.”

Investing reserves in long-term Treasury securities was good business for the banks so long as interest rates remained low, as they had been for years. But the sudden rate hike engineered by Federal Reserve officials in 2022 to combat inflation sunk the value of those bonds and decreased the market value of banks’ held-to-maturity assets, in turn forcing them to incur losses upon forced asset sales once depositors started to get nervous and pull out. 

The ongoing regional banking pressures are being caused not so much by greedy short sellers, but by reckless monetary policy from unelected bureaucrats at the Eccles Building in Washington, D.C., according to Thornberg. 

“The Federal Reserve made the choices that have caused the banks to fail,” he said. “And for them to sit around and point fingers at Silicon Valley Bank (SVB) and others and say, ‘You guys didn’t use the right term structure,’ well, no bank was prepared to deal with this insane roller coaster of monetary policy the Federal Reserve has put them all on.”  

University of Chicago’s Belton said those blaming the Federal Reserve for sparking the balance sheet pressures are failing to account for the Fed’s dual mandate of managing both inflation and unemployment rates, which were each severely impacted in recent years from the economic fallout of COVID-19. 

“The Fed’s got a really important job to do in terms of managing the overall economy. And raising interest rates is their primary tool for doing that, and they have to do that,” he said. “I don’t fault the Fed for raising rates, though you can fault them for not raising rates sooner.”  

Rather than blaming the threat of short selling or the stress posed by higher interest rates for the current crisis, a group of U.S. economists argued in a recent research paper that the banking system is under such intense stress today because its asset bases are largely made up of uninsured deposits, meaning those that exceed the Federal Deposit Insurance Corporation’s $250,000 threshold. 

Uninsured depositors represent a significant source of funding for commercial banks, accounting for about $9 trillion dollars of their liabilities, according to the March 13 research paper authored by Erica Jiang of University of Chicago, Gregor Matvos of Northwestern University, Tomasz Piskorski of Columbia University, and Amit Seru of Stanford

These uninsured depositors stand poised to create liquidity crisis after liquidity crisis, so long as they believe their money isn’t safe in any one particular bank, according to the economists.     

“If only 10 percent of uninsured depositors decided to withdraw their money, we would have 66 banks failing with about $210 billion of assets. If 30 percent of uninsured depositors ran instead, which is close to the share of withdrawals just preceding the shutdown of the SVB, we would have 106 banks failing accounting for $250 billion of assets,” said the research paper. 

“Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to even insured depositors, with potentially $300 billion of insured deposits at risk,” the paper concluded.  

The ratio of uninsured deposit base to total deposits was particularly high at the failed SVB and recently deceased First Republic Bank, exceeding 67 percent in both cases. But that same ratio is disturbingly high at some of the remaining regional banks now threatened with collapse. 

Zions Bancorporation carried $38 billion in uninsured deposits on $71.6 billion total deposits (53 percent); PacWest Bancorp carried $17.8 billion in uninsured deposits on $33.9 billion total deposits (52.5 percent); and Western Alliance Bancorporation carried $29.5 billion in uninsured deposits on $53.9 billion in total deposits (55 percent), according to the firms’ respective annual reports released in December. 

“All these banks should be terrified, and Jamie Dimon should be licking his lips,” said Thornberg, referring to the CEO of JPMorgan Chase, which has recently snatched up failed banks. “There’s blood in the water and the short sellers are attracted to it. 

“If the Fed doesn’t back off, there’s going to be massive consolidation in the U.S. banking system,” he added.   

Brian Pascus can be reached at bpascus@commercialobserver.com.