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Why do American banks collapse?

IFM_ American banks
Banks are exposed to a range of risks, including credit risk, market risk and liquidity risk

The collapse of banks in the United States is not a new phenomenon. Throughout history, the country has experienced several financial crises, with numerous lending bodies experiencing catastrophic bankruptcies. These collapses have also brought far-reaching effects on the economy, causing severe disruption, job losses and even recessions.

This year has seen the same sector coming into the news again, due to the downfall of three prominent regional banks. Now, let’s try to understand the factors which make the financial sector in the world’s largest economy a vulnerable one.

Just like how Rome was not built in one day, banking collapses in the United States have always been about the complex interplay of certain factors, on which this article will shed light upon.

Understanding the pain points

Major factors behind the bank failures in the world’s largest economy are financial mismanagement and risky practices. Banks are exposed to a range of risks, including credit risk, market risk and liquidity risk. When banks make poor lending decisions or take excessive risks, they endanger their financial stability.

For example, during the 2008 subprime mortgage crisis, several banks suffered significant losses from their exposure to high-risk mortgage-backed securities. In addition, inadequate risk management practices can amplify the impacts of these risks. Failure to accurately assess and mitigate risks can result in large losses, leaving banks unable to meet their obligations.

Poor risk controls and lax oversight can also lead to fraud and internal misconduct, leading to bank failures. The collapse of Lehman Brothers in 2008 is a stark reminder of the consequences of poor risk management. And add the collapses of Signature Bank, First Republic Bank and Silicon Valley Bank, again the high-risk securities angle is emerging.

Economic downturns and external shocks also play a crucial role in bank failures. Banks are very sensitive to fluctuations in the economy and financial markets. During recessions or periods of economic turbulence, the quality of the borrower’s creditworthiness deteriorates, leading to higher loan defaults and delinquencies. This adversely affects banks’ balance sheets, eroding their capital reserves and hampering their ability to absorb losses.

External shocks such as drastic changes in interest rates (decided by the US Federal Reserve) or falling asset prices can also trigger bank failures. When banks are exposed to highly volatile assets, sudden market movements can result in significant losses and bring them to the brink of bankruptcy. The collapse of Bear Stearns, an American investment bank in 2008 after the mortgage crisis is a prime example of how external shocks can rapidly deteriorate a bank’s financial condition. The year 2023 has seen the downfall of three prominent American banks one after another, with the Fed rate hike coming under the focus.

Poor regulation and inadequate supervision

In some cases, regulators fail to adequately identify or address emerging risks. Weak regulations, loopholes or poor enforcement can encourage risky behaviour by banks, creating a breeding ground for financial instability. Deregulation efforts in the late 20th century, such as the repeal of the Glass-Steagall Act in the US, allowed commercial transactions and investment banking activities to mix, contributing to increased risk-taking and the growth of complex financial products. This regulatory environment set the stage for the 2008 financial crisis, in which several banks engaged in practices that ultimately led to their collapse.

Also, inadequate reporting of financial information can obscure risk and mislead stakeholders and regulators alike. When a bank’s true financial condition is unclear, it becomes difficult to assess its solvency and make informed decisions. Financial institutions that employ aggressive accounting practices or fail to disclose relevant information can create a false sense of security. This can lead to market participants underestimating risk and making transactions based on incorrect information.

Enron’s collapse in 2001 highlighted the dangers of accounting irregularities and a lack of transparency, and how such practices can undermine the stability of banks and other financial institutions. Back then, the episode revealed that the American services company’s reported financial condition was sustained by an institutionalized, systematic, and creatively planned accounting fraud. Enron became synonymous with willful corporate fraud and corruption, thus raising permanent questions over the accounting practices of many American businesses.

The contagion effect

Banks are connected through various channels, including interbank lending, derivatives markets and counterparty relationships. When a bank fails, the shockwave spreads to other financial institutions due to interconnected risks. This can escalate quickly, undermining confidence in the entire banking system. Systemic risk is the possibility of substantial financial systemic disruptions brought on by the failure of one or more key institutions.

“Too big to fail” banks provide a systemic risk since their failure might have serious consequences for the whole economy. To reduce the systemic risk, the government frequently steps in to stop the collapse of these institutions, as witnessed in the 2008 financial crisis when the US government bailed out several sizable banks.

Asset quality and loan losses

The quality of a bank’s assets and its ability to absorb credit losses are key factors in a bank’s stability. Banks with high levels of non-performing loans (NPLs) or poor-quality assets face significant challenges. Bad loans are loans where borrowers default or are unable to make payments, indicating deterioration in credit quality. When banks have a significant volume of non-performing loans, this affects their profitability and capital adequacy.

In order to recover these losses, banks may have to build up significant provisions, which is likely to have a negative impact on their financial health. If the provisions are insufficient to cover the loan losses, it can lead to capital erosion and ultimately the bank’s collapse. In addition, banks that have concentrated exposure to a particular sector or industry are exposed to higher risks.

Economic downturns or sector-specific shocks can hit these banks disproportionately, leading to rapid deterioration in asset quality and potential insolvency. The collapse of numerous regional banks during the savings and credit crisis of the 1980s and early 1990s still reminds us of the risks associated with concentrated lending.

Let’s talk about overleveraging

Overleveraging is also one of the factors that contribute to bank failures. It refers to the practice of taking on excessive debt or using financial instruments to increase returns. While leverage can increase profits in favourable market conditions, it can also increase risks and exacerbate losses during downturns.

Heavily indebted banks are at risk of insolvency if their assets depreciate in value or they are unable to pay their debts. Meanwhile, inadequate capitalization is closely related to overleveraging. Capital serves as a buffer against losses and helps banks absorb unexpected shocks. If a bank does not have sufficient capital, it may not be able to absorb losses due to its risky activities or significant falls in the value of its assets. This can lead to a downward spiral as losses erode capital and further weaken banks’ ability to remain solvent.

The regulatory framework aims to ensure through capital adequacy requirements that banks have sufficient capital buffers to withstand adverse events. However, if banks fail to comply with these requirements or the regulations are not strict enough, it can lead to institutional failure. The collapse of several banks during the Great Depression of the 1930s due to excessive leverage and insufficient capitalization led to the introduction of stricter regulations and capital adequacy standards.

Technological, political and legal factors

As banks increasingly rely on technology and digital infrastructure to conduct their business, they become vulnerable to disruption from system failures, cyberattacks or data breaches. These can not only lead to financial losses, but also undermine customers’ trust in the bank. Cyber threats pose a constant risk to the security and integrity of banking systems and customer data. A successful cyberattack can result in financial loss, reputational damage and possibly legal and regulatory consequences. The collapse of Mt. Gox, a well-known Bitcoin exchange, in 2014 due to a massive cyberattack highlights the risks associated with technological vulnerabilities. Banks must continuously invest in robust cybersecurity measures, regularly update their technology infrastructure and improve their resilience to ensure they are adequately protected against cyber threats.

Political and legal factors can also contribute to bank failures. Changes in government policies, regulations or economic ideologies can have a significant impact on the banking sector. For example, sudden shifts in regulatory priorities or changes in tax laws can create uncertainty and disrupt banks’ business models.

Political interference or interference in the business activities of banks can also jeopardize their stability. When political pressures influence lending decisions or create an environment of corruption and mismanagement, it can undermine the soundness of banks and increase the risk of failure.

The 2023 misfortune

According to the Silicon Valley Bank website, the bank has provided banking services to nearly half of the nation’s venture-backed technology and life sciences companies, as well as more than 2,500 venture capital firms. For decades, the Silicon Valley bank was awash with cash from high-flying corporate start-ups doing what most of its competitors did: keeping a small portion of their deposits in cash and using the rest to buy long-term debt like Treasuries. These investments promised stable, modest returns when interest rates stayed low. But it turned out that they were short-sighted. The bank had failed to consider what was happening in the broader economy, which was overheating after more than a year of pandemic-related stimulus measures.

This meant that the Silicon Valley bank was left in the lurch when the Federal Reserve began raising interest rates to fight rapid inflation in 2022. These once safe haven assets looked significantly less attractive as newer government bonds attracted more interest.

But not all of Silicon Valley Bank’s problems are related to rising interest rates. The uniqueness of the bank in some ways contributed to its rapid decline. With the bank’s business focused on the tech industry, Silicon Valley Bank ran into trouble when start-up funding began to dwindle, causing its customers, a mix of tech start-ups and their executives, to use their accounts more.

The bank also had a significant number of large uninsured depositors, investors who tended to withdraw their money at signs of turbulence. In order to meet the needs of its customers, the bank had to sell some of its investments at a deep discount. When Silicon Valley announced its huge loss, the tech industry panicked and start-ups rushed to withdraw their money, leading to the demise of the bank.

The Federal Deposit Insurance Corporation (FDIC) announced that it would acquire the 40-year-old institution after the bank and its financial advisors tried unsuccessfully to find a buyer. The takeover saw approximately $175 billion in customer deposits out of the control of federal regulators.

The FDIC, created by Congress in 1933 to insure banks for consumer deposits, is responsible for maintaining stability and public confidence in the country’s financial system. The collapse of Santa Clara-based SVB is now the largest since the 2008 financial crisis and created a contagion effect in the US banking circle.

Miscalculation from Trump?

After 2008, US Congress passed the ‘Dodd-Frank Financial Regulation Package’, designed to prevent such collapses. In 2018, President Donald Trump signed legislation reducing the number of Federal Reserve stress tests on regional banks. As news of Silicon Valley Bank’s failure broke, experts said the Dodd-Frank package might have forced the bank to better manage its interest-rate risks had it not been scaled back.

On the other hand, New York regulators abruptly shut down Signature Bank in a bid to curb risk in the financial system at large, just two days after the FDIC took over the SVB’s control.

The Signature Bank, which provided lending services to law firms and real estate companies, had less than $100 billion in deposits in 40 branches across the country. The bank’s clients included some people associated with the Trump organization. In 2018, the 24-year-old bank began taking deposits from crypto assets – a fateful decision after the industry hit rock bottom following the collapse of cryptocurrency exchange FTX.

Like Silicon Valley Bank customers, most Signature Bank customers had more than $250,000 in their accounts. The Federal Deposit Insurance Corporation only insures deposits up to $250,000, so any deposits in excess of this do not receive the same federal protections. According to regulatory filings, nearly nine-tenths of Signature Banks’ approximately $88 billion in deposits at the end of 2022 were uninsured. As Silicon Valley Banks’ troubles began to spread, many Signature customers panicked and began calling the bank, concerned their own deposits might be at risk.

The demise of both Silicon Valley Bank and Signature Bank spotlighted the challenges facing small and mid-sized banks, which tend to focus on niche businesses and can be more vulnerable to bank runs than larger competitors, experts stated. The main concern is that the failure of one bank would deter customers from other banks.

Recently, the smaller banks rushed to reassure customers that they were on a stronger financial footing. The US regional bank shares plummeted as investors tried to get a handle on the sudden collapse of Signature Bank and Silicon Valley Bank. The stock value of small banks in the United States fall drastically, starting with the First Republic Bank which suffered a downfall of 60%, Arizona’s Western Alliance fell 45%, KeyCorp and Comerica both fell nearly 30%, and Utah’s Zions Bancorp fell about 25%.

Stocks of larger banks weren’t as hard hit. Citigroup and Wells Fargo each fell more than 7%, Bank of America fell more than 3% and JPMorgan lost about 1%. The KBW bank index, which tracks the performance of 24 major banks, fell 10%, leading to sharp losses that eroded the total value of banks in the index by nearly $200 billion.

The 2023 banking collapse in the United States has been the culmination of a complex interplay of factors ranging from financial mismanagement and economic downturns to regulatory weaknesses. To mitigate these risks and ensure the stability of the banking system, a multifaceted approach is required.

Strengthening risk management practices, improving regulatory frameworks, promoting transparency and disclosure, and addressing challenges posed by technological disruption and cyber threats are critical steps. In addition, adequate capitalization, prudent lending practices and effective supervision are essential for banks to weather economic downturns and external shocks. By addressing these factors and learning from past experience, regulators, policymakers and market participants can work towards building a more resilient financial system, better equipped to weather challenges and contribute to sustainable economic growth.

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