Dead man walking

April 28, 2023

As I wrote in this column on March 16, the failure of Silicon Valley Bank (SVB)—the second-largest bank failure in US history—was significant. It was followed within days by the third-largest bank failure in US history (Signature Bank) and the forced sale of Credit Suisse to its arch-rival UBS. It now appears that First Republic Bank (FRC) is “dead man walking” as depositors yanked more than $100 billion from it during March and its stock price plunged 95 percent below its 52-week high.

The current financial stress is caused by the failure of banks to adequately prepare for a period of rising interest rates. For years, they have gorged themselves on the Fed’s near-zero interest rate policy largesse. They now face two risks that could have been avoided. The first is disintermediation. The second is interest rate risk. These risks affect all banks and will be evident in the months ahead. Here is how they work.

Banks fund themselves by borrowing money from depositors. If a bank’s deposit rates are not competitive with other alternatives, depositors take their money elsewhere and the bank suffers disintermediation. This is the case today. The current national average rate on a 1-year bank CD is 1.7%. In comparison, US Treasury bills pay around 4.9% and money market funds pay as much as 5.1%. Large depositors have a choice. They can leave their funds in an uninsured low-rate CD, or they can invest their funds in a Treasury Bill where they get almost three times the yield, and the full-faith-and-credit guarantee of the Federal government. Most rational investors will take the T-Bill option and that is exactly what is happening.

SVB suffered disintermediation in the months leading up to its failure. Deposits peaked early last year at $198 billion and fell to $175 billion at year-end. On March 9, as panic set in, depositors pulled an additional $42 billion from the bank in a single day prompting the Fed to step in. FRC had a similar experience: disintermediation that accelerated into a panicked run on the bank.

So, why don’t banks pay more on their deposits? Some do, but many can’t. Banks that are considered “less than well capitalized” are subject to an FDIC rule that limits their maximum CD rate to the national average plus 75 basis points. Other banks are constrained by the impact higher deposit rates would have on their profitability. This leads us to the second risk: interest rate risk.

Interest rate risk is inherent in most banking operations. It is a two-edged sword. On one hand, it is a powerful engine for profits when rates fall. On the other hand, if not managed well, it can bring disaster when rates rise. Unmanaged interest rate risk crushed the savings & loan industry in the early 1980s and it is wreaking havoc on regional banks today.

If you have a 30-year fixed rate mortgage, you may be part of a bank’s interest rate risk problem. Let’s suppose you refinanced your mortgage two years ago at a rate of 3 percent. Deposit rates were close to zero, so the bank that wrote your mortgage probably earned a net interest spread (i.e., the difference between what it earns on its assets and what it pays on deposits) of almost 3 percent. Today, that bank is probably paying 1.7 percent on its deposits, but it is still only earning 3 percent from your mortgage. Its net interest spread has declined from almost 3 percent to barely 1.3 percent. Banks are experiencing a violent squeeze in their profits.

In the 1980s, banks learned to manage their interest rate risk by hedging against interest rate increases. However, a recent study by a group of economists from USC, Northwestern, Columbia, and Stanford found that very few banks are actually hedging. They also found that banks with the most fragile funding (i.e., those with large uninsured deposits), sold or reduced their hedges during last year’s monetary tightening.

What does this mean for the rest of us? It means that banks will be a source of fragility in the months ahead. SVB and FRC used to be two of the largest and most respected lenders in the Bay Area. Those days are gone. Going forward, banks will be less likely to extend credit and more likely to foreclose on struggling credits. Ongoing banking sector stress means a recession is much more likely in the coming months.

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Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey.   He welcomes questions you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to