2023-05-08 12:33:18
After last week’s collapse of First Republic, the collapse of three former banks and the Federal Reserve’s quarter-point rate hike, its tenth straight increase in an effort to curb rising inflation, a Stanford Graduate School of Business finance professor issued a grim warning that that regional banks will collapse like dominoes.
The Stanford professor in the New York Times “Yes, there is a potential banking crisis to worry about” he described his gloomy views in his opinion article. Professor Amit Seru wrote that “several prestigious banks are fragile and their collapse is unlikely to be an isolated phenomenon“. According to him “the harmful combination of rapidly rising interest rates, major changes in working methods and a potential recession could trigger a credit crunch not seen since the financial crisis of 2008”.
In the past few months alone, several major US banks have gone bankrupt: Silicon Valley Bank, Signature Bank and First Republic Bank. The combined assets of these banks exceeded the assets (adjusted for inflation) of the 25 banks that failed at the height of the 2008 financial crisis. While some experts and policymakers believe Monday’s resolution of First Republic Bank signals that the industry’s turmoil is coming to an end, many say it’s too early to tell. Shares of PacWest and Western Alliance fell on Thursday as investors grew nervous. Adverse market conditions have now significantly weakened the ability of many banks to withstand another credit shock. And it’s clear that a major market shock could be on the way.
The Fed’s interest rate hike is just fuel to the fire
Rapidly rising interest rates create dangerous market conditions for banks due to a basic principle: the longer the term of an investment, the more sensitive it is to changes in interest rates. When interest rates rise, the value of assets held by banks to earn a return on their investments falls. And because banks’ liabilities, such as deposits that customers can withdraw at any time, tend to have shorter maturities, they decline less. Thus, rising interest rates can deplete the bank’s equity capital. There is a risk that the bank will have more liabilities than assets. Thus, it is not surprising that the market value of the assets of the American banking system is about $2 trillion lower than their book value suggests. If we look at the entire circle of approximately 4,800 banks operating in the United States, the decrease in the value of equity capital is most noticeable in the case of medium-sized and smaller banks, which reflects their larger bets on long-term assets.
It was given to The Guardian in his interview Seru was more precise about exactly how many banks burned their capital buffers and went under water. The estimate is staggering: almost half of the 4,800 banks in the USA.
“Awesome. Thousands of banks are in big trouble right now. Let’s not pretend this is just about Silicon Valley Bank and First Republic. Much of the US banking system is potentially insolvent.”
Since monetary tightening operates with a long delay (9-12 months), many of the interest rate increases of the past year have not yet filtered through to the real economy. In the coming quarters, the American banking system will face its toughest challenge yet. This is because the tightening of credit standards can cause further breaks in the system.
Seru noted in his article: “However, there is another threat of serious concern that could trigger such panic: the commercial real estate sector”.
The real estate sector is also on shaky ground
In the United States, commercial real estate loans make up about a quarter of the average bank’s assets. The total value of commercial real estate loans is currently approximately $2.7 trillion. Many of these loans will mature in the next few years. Their refinancing at higher interest rates naturally increases the risk of non-payment. Rising interest rates also reduce the value of commercial real estate. Especially properties with long-term leases and limited rent increase clauses, which also increase the likelihood of landlords defaulting. During the Great Recessions, for example, as interest rates rose, the default rate rose from the previous 1 percent to about 9 percent.
Finally, it is interesting that this current apocalyptic warning about the US banking system comes when JPMorgan CEO Jamie Dimon claims that “the system is very, very stable”.
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