IN-DEPTH: Key Risks Facing Banks and What Americans Can Do About Them

IN-DEPTH: Key Risks Facing Banks and What Americans Can Do About Them
A security guard at the failed Silicon Valley Bank monitors a line of people outside the office in Santa Clara, Calif., on March 13, 2023. (Justin Sullivan/Getty Images)
Tom Ozimek

While the threat of financial contagion has abated following the bank turmoil sparked by the collapse of Silicon Valley Bank (SVB), experts warn that there are still risks facing U.S. banks that Americans should be mindful of.

The collapse of SVB sent shockwaves through the U.S. banking sector, sparking a crisis of confidence and an acceleration of deposit outflows.

In the weeks since SVB failed on March 10, commercial banks in the United States have seen a deposit exodus of just over $350 billion, Federal Reserve data show.

While that’s a fraction of the $17.3 trillion deposit base in U.S. banks, the outflow pressure was intense, especially from smaller banks.

In the first week following the SVB failure, deposits at banks smaller than the biggest 25 fell by $119 billion, a record drop.

‘Fundamental Weaknesses’

The turmoil that followed the failure of SVB prompted financial authorities to rush through measures like an emergency bank lending facility from the Federal Reserve so banks could meet depositor demand for withdrawals and prevent bank runs.

While deposit outflows have stabilized over the past several weeks, the U.S. banking sector isn’t yet out of the woods.

“The U.S. banking sector continues to have fundamental weaknesses that have been contained due to liquidity injections and short term loans,” Daniel Lacalle, chief economist at hedge fund Tressis, told The Epoch Times in an emailed statement.

“But the core problem remains: the profitable asset base has been destroyed by years of negative real rates,” Lacalle added.

Negative real rates occur when nominal interest rates—those typically quoted by banks on loans and other financial products—are lower than the rate of inflation. Banks have a harder time turning profits when interest rates are low.

Before soaring prices forced the Fed to start hiking interest rates last March, there was a period of over a decade where the central bank expanded its balance sheet by buying government securities, driving interest rates to near zero, and flooding the economy with cheap money.

Analysts say many banks took added risks to increase investment returns during years of very low interest rates and some may have failed to hedge against the risk of rising interest rates.

“Deposit outflows have also forced banks to sell assets at a loss that they had intended to hold to maturity in order to generate the cash required to cover deposit withdrawals,” Ben Johnston, chief operating officer of Kapitus, a provider of financing for small and medium-sized businesses, told The Epoch Times in an emailed statement.

“These losses have reduced the equity value of the banks, weakening their ability to withstand future losses, and worrying their customer bases. While fear in the banking system has subsided, these risks have not gone away,” he added.

Investor Warren Buffett predicted recently that “we’re not through with bank failures,” while JPMorgan CEO Jamie Dimon wrote in a letter to shareholders that even when the current crisis is behind us, “there will be repercussions from it for years to come.”

“The current crisis has exposed some weaknesses in the system,” Dimon wrote, adding that America faces a range of “unique and complicated issues.”

In remarks to The Epoch Times, a number of experts have detailed some of the vulnerabilities still remaining in the U.S. banking sector and suggested what Americans can do to mitigate some of these risks.

Interest-Rate Risk

The collapse of SVB was prompted by a $1.8 billion loss that the bank took when it liquidated its $21 billion bond portfolio that had dropped in value because the Federal Reserve raised interest rates.

Michael Collins, a professor at Endicott College and CEO of Wincap Financial, told The Epoch Times in an emailed statement that America’s banking sector continues to face risks from more rate hikes, which Fed officials have said are likely.

“The U.S. banking sector needs to strengthen their internal risk management systems, increase their cybersecurity, and focus on improving capital management strategies,” he said. “It also needs to work closely with regulators to ensure that it is able to comply with regulations efficiently and effectively.”

Collins added that, at an individual level, “Americans can reduce their exposure to these risks by making sure that they select a bank with a good track record of security and compliance, as well as one that is well regulated and financially sound.”

One of the banks that failed to safeguard against interest rate risk was SVB.  A top U.S. regulator told a Senate panel at the end of March that SVB did a “terrible” job of managing risk before it failed.

Michael Barr, the Fed’s vice chairman for supervision, criticized SVB for how it modeled interest-rate risk, which he said “was not at all aligned with reality.”

Barr added that Fed supervisors flagged the issues with bank management, but those went unaddressed.

“The risks were there, the regulators were pointing them out, and the bank didn’t take action,” he said.

When interest rates rise, it affects the market value of assets, especially fixed-income securities like government bonds. If interest rates rise quickly, banks may experience losses on their mark-to-market assets, though losses on their held-to-maturity assets may not be reflected in their financial statements until those assets mature.

“Since the Fed has raised rates so fast over the past year, there will be mismatches between mark-to-market and assets that are not marked, because they are held to maturity. Many banks are in this situation,” Chris Ainsworth, chairman and CEO of Pave Finance, told The Epoch Times in an emailed statement.

The Fed’s emergency lending facility rolled out in the wake of the SVB collapse lends to banks against collateral based on par value instead of the marked-to-market value of holdings. This, according to Ainsworth, will ensure banks have access to capital they may not have be willing to get prior to the launch of the program.

Still, rising interest rates “will continue to cause stress for companies and other borrowers that have rates resetting going into the second half of the year,” Ainsworth said.

“There are huge amounts of commercial real estate and corporate bonds that will reset at much higher rates, making it difficult for borrowers to meet their obligations,” he added.

“The easiest thing for people to do to protect themselves is hold cash they need access to in a government money market fund,” he said.

While government money market funds typically pay slightly lower rates of interest than other money market funds, they offer added security because they’re guaranteed not to break the net asset value (NAV) of $1 per share.

Some money market funds have a “floating NAV,” meaning their share price might fluctuate based on changes in the market value of underlying assets.

Markets expect the Fed to raise rates at least one more time during this rate cycle. If inflation proves more persistent, the Fed might take them higher still.

“Additional rate increases would continue to weaken the deposit base, profitability, and capital position of many U.S. banks,” Johnston told The Epoch Times.

Johnston said it’s hard for business customers to predict the exposure of a given bank to interest-rate risk.

“However, businesses should have multiple banking relationships and keep sufficient funds at each of these institutions. This will ensure access to funds in the short-term if one bank were to fail,” he added.

Faron Daugs, founder and CEO at Harrison Wallace Financial Group, told The Epoch Times in an emailed statement that he expects bigger U.S. banks to remain mostly unaffected by the sharp rise in interest rates over the past year.

Smaller banks face considerable risk because they are less diversified in their deposit and loan base than their bigger counterparts, Daugs said.

But a bigger worry than interest-rate risk for banks is their exposure to commercial real estate, Daugs believes.

Commercial Real Estate

Some analysts have said that one of the biggest concerns U.S. commercial banks face today is exposure to the commercial real estate market.
Billionaire investor Howard Marks said in a memo that a looming wave of mortgage defaults could add to U.S. banking sector stress.

“We’re very likely to see mortgage defaults in the headlines, and at a minimum, this may spook lenders, throw sand into the gears of the financing and refinancing processes, and further contribute to a sense of heightened risk,” Marks said.

“Developments along these lines certainly have the potential to add to whatever additional distress materializes in the months ahead,” he added.

In his remarks to The Epoch Times, Daugs said that big property owners face hurdles as they look to refinance a massive pile of loans taken when interest rates were lower.

“The bigger issue for this year is the $1 trillion worth of refinancing and commercial real estate due this year,” Daugs said.

Ultra-low interest rates led to commercial real estate borrowing that was financed at very low rates.

“Now they’re going to have to refinance at probably 3 to 4 to 5 percent higher than where they were, and many of them are just not going to be able to afford to do that,” he said.

“Our concern is potential defaults and foreclosures, and that’s something that’s looming in the bigger banking system that we have to be very cognizant of,” he said.

To mitigate the impact of the risk on their investment portfolios, Daugs advised Americans to become knowledgeable about the sectors they’re investing in.

“If you’re concerned about the volatility of a certain area, stay away from it and wait until the dust settles on some of the issues,” he said.

Jack Prenter, CEO at Dollarwise, told The Epoch Times in an emailed statement that he, too, sees defaults coming on commercial real estate loans. But for everyday Americans, the bigger risk is having too much high-interest debt.

As interest rates rise and borrowing costs increase, people should focus on reducing their credit card debt and generally be more cautious about taking out more loans, according to Prenter.

“Stop taking out long-term loans to buy vehicles that you can’t afford. Now is the time to buckle down and cut your spending as much as possible,” Prenter said.

Ari Rastegar, founder and CEO of the Rastegar Property Company, told The Epoch Times in an emailed statement that a “major risk” still facing the U.S. banking sector are all the office loans that are coming to maturity.

Rastegar said that now’s the time when “ordinary Americans need to really watch their budgets and really make sure sure that they’re not over-spending with discretionary spending.”

“But the good part is that this will be very, very short-lived and there’s a very, very bright future economically ahead,” Restagar predicted.

Tom Ozimek is a senior reporter for The Epoch Times. He has a broad background in journalism, deposit insurance, marketing and communications, and adult education.
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