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The Depositor's Conundrum

We discuss the unfolding banking crisis in the US, and explore how far it could spread and what are the implications for depositors and litigators around the world.


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A row of piggy banks: a metaphor for the small savings banks that are in trouble

Bank failures make people feel nervous. Money is energy, and the idea of a lifetime's savings evaporating should make any normal person tingle a little. Here’s the summary of what’s going on, why and how it will affect you and your litigation practice …


This weekend a fourth US bank is likely to fail. We explore, what is happening, consider how far it will go, and what you should do about it.


Why is this happening?


It all began with Silicon Valley Bank (SVB). Realising that it would be a good idea to bolster its capital base, raising equity capital, but that deal fell through. The Venture Capital community, concerned for their Start Up companies (that held deposits at SVB), advised founders and small tech firms that made up much of SVB’s depositors, to move their deposits.


A trickle turned into a flood, and as depositors fled, the bank’s share price plummeted and confidence was lost and the bank collapsed in days. The speed of collapse surprised all and appears to be a function of technology: depositors no longer queue in lines, but deposits flood out at the click of a button.


The Federal Reserve investigated SVB’s failure and found failures by management and supervisors, with recommendations for the future. We don’t think that it's over.


Post-mortems revealed the bank had built up interest rate risk in Covid era of ultra-low interest rates. When the Fed was forecasting low rates for longer, SVB purchased long-term debt.


Banks historically have two functions: (a) credit transformation (guarantee depositors, whilst lending risky loans) and (b) maturity transformation (depositors redeem instantly, whilst the bank lends long term).


As inflation rose, Central Banks were forced to raise rates, and the US Fed did so very quickly indeed.


That left many of the long term bond holdings of small banks under water. Why didn’t they hedge this interest rate risk? Well the whole point of investing in longer bonds was to benefit from the higher interest rates, so hedging would have undermined that purpose (as the cost of hedging should counteract the benefit of the risk).


The Regulators Report


Fed Vice Chair Barr, released a post mortem on SVB. It criticised SVB’s management and also the Fed itself. Concentrations of depositors and excessive interest rate risk, were some failings. The Supervisors also need to have tools to transition banks to greater supervision as they grow.


President Biden assured voters that this time investors (equity holders and bond holders) would not be bailed out, and so in the rescue investors lost most of their investment.


Using the Feds new (post GFC) powers, the rescue itself was orderly. The Fed quickly set up a lending new programme. However, the damage was done.


The aftermath


That failure shone a spotlight on the entire small bank sector. As we have argued before (see article on small banks being structurally weak), small banks have always faced head winds, and banking crises are not new. Over the past six decades, 14,000 US small banks have shrunk to circa 4,000. However, this time it’s different.


Historically, regulators have stepped in much earlier, sometimes bailing out investors in the process. After the Great Financial Crisis, changes were made to prevent the ‘socliaisation of losses and the privatisation of profits’. The Biden speech echoed that philosophy: investors won’t be bailed out.


This is leading to equity investors re-evaluating their investments. Even with the Fed programme, which simply provides liquidity, the fact remains that these bank’s have structural disadvantages (that we explained in our piece).


Shares in small banks have started to drop. PacWest is down over 90% since April 28th, with buyout talks with Toronto Dominion having failed earlier in the week, it wouldn’t surprise anyone if it was rescued this weekend.


It is unclear whether there is anything particularly adverse about PaciWest. Some bank analysts (RBC for instance) have stuck with the stock, presumably after having done their homework.


But as the chart shows, it looks pretty bleak at the moment.


Chart of PacWest share price: falling over 90%  in recent months

Chart from Yahoo Finance


How far will it spread?


Share prices in other banks are also falling. In the past fortnight, Western Alliance is down 70%; First Horizon and Homestreet down 60%; the majority of small banks down 25% and everything else in between.


Given the structural issues with small banks, there is no reason to expect this to be limited to the US.


The Bank of England floated the idea of raising the limits on the deposit guarantee scheme. And doubtless central banks across the world are watching this with interest. The market structure of small and big banks is not limited to the US. During the Great Financial Crisis, it was many of the small German savings banks that held some of the most risky structured credit assets.


And so it follows that this is now not a US centric problem, but a problem of small banks in the age of technology.


Where do we go from here?


Warren Buffet, the legendary investor and founder of Berkshire Hathaway, was sanguine. 'US depositors will not lose money,’ he said in a recent interview. And so far they haven’t. So far failing banks have found new homes. The losers have been shareholders and bondholders, and depositors have been adopted by the new institutions.


In the past, the Federal Reserve would have been planning some form of rescue package to prevent the collapse of the sector. Where systematic bad lending had taken place, perhaps the syphoning off of bad assets into a ‘government sponsored bad bank’ would have been the outcome. Or other mechanisms to bolster the capital of the bank, like the government taking a stake in the bank.


Worried market participants are looking for something similar today. However, we think it is more likely that the Federal Reserve does very little. That’s because it has the tools to deal with this crisis, and demonstrated them during the First Republic banking sale.


JP Morgan received a ‘Loss Sharing Agreement’ from the Federal Reserve. That is because, with the shares effectively written down, the only source of real uncertainty was on the quality of First Republic’s loan portfolio. The Federal Reserve seemed confident that the loan portfolio was fine and so agreed to share losses on the loan portfolio with JP Morgan.


With tools like this in the Fed’s arsenal, we can see why they, like Mr Buffet, appear, relatively, sanguine.


Will there be rescues elsewhere?


The only place we have seem a material wipe-out of depositors was in Cyprus in 2013. There deposits over the limit of EUR 100,000 were bailed-in. Given the majority of those were with foreign owners (taking advantage of Cyprus’ tax benefits) it had limited political repercussions.


In other circumstances, governments and regulators are likely to be more careful, but none-the-less it shows the bail-in of depositors to rescue the bank and so stop taxpayers paying the bill is on the cards.


The fact is that post GFC we are in a new environment. Bank shareholders and bond holders can be wiped out and quickly. The consensus is that investors should certainly not be bailed out. Further, depositors are no longer sacrosanct.


However, as is clear from measures like the 'Loss Sharing Agreement', regulators have lots of flexible tools, and so where bank loan books are not compromised the process should be as smooth as it has been in the US for the past couple of months.


None-the-less, the destruction of value amongst bank shareholders is leading to nervous markets. And those falling share prices are resulting in deposit flight. After all why risk it? That makes small banks have to pay more but that makes their structural problem worse.


The fact is that the raison d’etre of the small bank is over. It no longer has an advantage where it knows a local community, assesses their credit and so places a role in the modern monetary system.


Should you be concerned?


The answer is probably not. Unlike 2008, central banks have a wide toolkit. As a depositor, you are more protected than shareholders and bondholders, who today are wiped out very quickly. Just ask the Credit Suisse AT1 bond holders. Further, the central bank toolkit (which they keep referring to in speeches) has so far proved potent.


That said, in a systemic crisis (where a country is in trouble), under the philosophy of the post 2008 world, regulators should wipe out depositors too (ala Cyprus). And so that is likely the best way to think about the risk to depositors. Does your country have wider systemic problems?


However, whilst this certainly isn’t financial advice, we have certainly diversified our deposits across financial institutions to be at or near the guarantee scheme limit. For savings beyond that, exploring fund solutions may make sense. Assuming that the broker has segregated accounts then you should have recourse to your underlying assets when you buy government securities or money market funds through a broker. That said, when things go wrong, all of this theory gets tested, sometimes with adverse outcomes.


For litigators we discuss the consequences and opportunities in Litigation Hotspots. Connect here to be invited.


We are banking expert witnesses, and our panel includes some of the world's leaders on bank resolution and bail-ins. We also have a wide variety of other specialists in other fields of banking, asset management, derivatives and blockchain.


Resources:


FDIC statement on JP Morgan deal

https://www.fdic.gov/news/press-releases/2023/pr23034.html


Chairman Powell Q&A after rate hike:


Vice Chair for Supervision, Michael S. Barr’s Report on SVB

https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230428a.html


Small banks article

https://www.acumenexpertwitness.com/post/time-s-up-for-small-banks


PacWest new lows


Upgrading small bank stock

https://www.barrons.com/articles/pacwest-western-alliance-first-horizon-stocks-banks-8940761a?mod=md_stockoverview_news


Cyprus bank bail-in


Article on Credit Suisse AT1 bonds


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