American banks face a looming credit risk

As Jay Powell, Federal Reserve chair, faced the media on Wednesday after a 25 basis point rate hike, he tried to put a brave face on his country’s bank turmoil. “Our banking system is sound and resilient, with strong capital and liquidity,” he declared, promising that the Fed, Treasury and Federal Deposit Insurance Corporation would do everything to quell the panic unleashed by the failure of Silicon Valley Bank.

Maybe so. The Fed supplied an eye-popping $152bn of liquidity to banks last week. But investors remain decidedly unimpressed — shortly after Powell spoke, bank stocks slid, with particular declines in weaker groups such as First Republic.

It might be tempting to blame the malaise on the Fed’s hike, but that is only a small(ish) part of the tale. The bigger issue is that America’s small and medium-sized banks are grappling with three interrelated problems: a deposit flight; an eroding business model; and a credit crunch.

Take the deposit problem. This has arisen because the FDIC’s mandate only protects deposits up to $250,000 if a bank fails, unless there is a “systemically important” reason to extend wider coverage.

Before SVB collapsed it seemed that “systemic” meant big banks. Hence when SVB and Signature wobbled, customers moved funds to the too-big-to-fail giants. However, the FDIC then subtly reinterpreted this mandate, and protected all deposits at SVB and Signature, supposedly because of systemic contagion risks. As Powell noted on Wednesday, “history has shown that isolated banking problems, if left unaddressed, can undermine confidence in healthy banks and threaten the ability of the banking system as a whole”.

But Janet Yellen, US Treasury secretary, also revealed on Wednesday that the Treasury and FDIC do not plan to offer blanket guarantees for depositors in advance, without Congressional support. Ambiguity still reigns. This will almost certainly spark more outflows from smaller banks.

The next issue is the banks’ business models. During the past decade banks enjoyed abundant cheap funding because their customers left their money in low-yielding bank accounts due to a lack of better alternatives. The banks then made profits by extending loans at slightly higher rates and buying long duration assets such as treasuries.

But customer behaviour is shifting. Not only is there a flight from smaller banks to larger ones, but deposits overall are moving into money market funds. And the loss of cheap funding hurts since banks still have loans on their books extended at low rates. Worse still, rate swings have created unrealised losses in banks’ securities portfolios, totalling $620bn across the industry at the end of 2022, according to the FDIC.

Thankfully these do not usually need to be booked, unless a bank fails. And most banks are less likely to fail than SVB, because they have fewer uninsured depositors. But even if SVB-style dramas can be avoided, the pattern is creating “a long tail of zombie banks”, as the hedge fund Bridgewater says. “Policymakers can stop a bank run but unless the Fed cuts rates they can’t stop the repricing in banks funding costs.”

That feeds into a third issue: a credit crunch. As funding costs rise, banks will cut loans. In some senses this is what Fed officials want, since slower credit creation will curb inflation. But the rub is that it is extremely hard to predict the impact of a credit squeeze since it can create a self-reinforcing downward spiral of recession and defaults. So while the crisis in American banks was initially sparked by interest rate (and liquidity) risks, it could now slowly morph into a problem of credit risk too.

The $5.6tn commercial real estate lending market illustrates the problem. At present 70 per cent of these loans comes from small and medium-sized groups. “Small banks’ absolute dollar exposure to CRE lending has grown at an accelerating rate over the past ten years,” notes Morgan Stanley;

Even before the interest rate cycle turned, CRE values were starting to come under pressure because the rise of internet shopping and homeworking hurt retail and office space. But with rates rising, “all of a sudden those assets become very hard to roll over” as Rick Rieder of BlackRock says. Since $2.5tn of loans are due to be refinanced in the next five years, this will eventually create pain for borrowers — and banks.

The good news is that the CRE problems do not seem to be nearly as grave as the issues in subprime mortgages in 2008. And there is plenty of capital in the American bank system as a whole to absorb such credit losses.

Moreover if the problems at small banks spark consolidation, via mergers or failures, this would be welcome. In the past, American politicians have taken pride in their country’s large number of banks — currently sitting at more than 4,000 — as a sign of competition and consumer choice. But it does not serve the country well to have a long “zombie tail”.

However, the bad news is that this trifecta of problems means that anyone who hopes for a quick resolution to the bank woes will be disappointed. If the FDIC extends insurance, that would reduce the panic. A halt to rate rises would reduce the business squeeze. But today’s mess is the result of a decade of policy mistakes and will not be fixed in 10 days or 10 months; particularly if the next chapter of the drama now moves from interest rate risks to credit woes.

gillian.tett@ft.com