The collapse of First Republic Bank last week, coupled with the meltdown of three other banks and the Federal Reserve’s quarter-point increase, marks the tenth straight hike in an aggressive campaign to tame elevated inflation. According to Professor Amit Seru, a finance professor at the Stanford Graduate School of Business, the recent failures of high-profile banks are most likely not an isolated phenomenon, and the collapse of these banks is indicative of a larger problem facing the US banking system.
In a New York Times opinion piece titled “Yes, You Should Be Worried About a Potential Bank Crisis. Here’s Why,” Professor Seru warned that a damaging combination of fast-rising interest rates, major changes in work patterns, and the potential of a recession could prompt a credit crunch not seen since the 2008 financial crisis. In the past few months, Silicon Valley Bank, Signature Bank, and First Republic Bank have failed, with their combined assets surpassing those held by the 25 banks that collapsed at the height of the financial crisis.
While some experts and policymakers believe that the turbulence in the industry is coming to an end, Seru believes that this may be premature. According to him, adverse conditions have significantly weakened the ability of many banks to withstand another credit shock, and a big one may already be on its way.
Rapidly rising interest rates create perilous conditions for banks because the longer the duration of an investment, the more sensitive it is to changes in interest rates. When interest rates rise, the assets that banks hold to generate a return on their investment fall in value, while the banks’ liabilities, like deposits, which customers can withdraw at any time, fall by less. Thus, increases in interest rates can deplete a bank’s equity and risk leaving it with more liabilities than assets. The US banking system’s market value of assets is around $2 trillion lower than suggested by their book value, with the decline in the value of equity being most prominent for midsize and smaller banks.
According to Seru, almost half of America’s 4,800 banks are burning through their capital buffers and are underwater. The estimate is shocking and highlights the fact that the US banking system is potentially insolvent. With monetary tightening working in long lags of 9-12 months, many of the rate hikes over the last year have yet to filter through the real economy, and the US banking system will face its toughest challenge yet in the coming quarters, as tightening lending standards might spark more breaking.
Seru also notes that the commercial real estate sector is another looming area of concern that could spark such panic. Commercial real estate loans, worth $2.7 trillion in the United States, make up around a quarter of an average bank’s assets. Many of these loans are coming due in the next few years, and refinancing them at higher rates naturally increases the risk of default. Rising interest rates also depress the value of commercial properties, especially those with long-term leases and limited rent escalation clauses, which also increases the likelihood of owner default.
