Bank crisis is spreading into its next – more damaging – phase
After the initial shock of the most recent financial implosion, we are entering the next chapter: the slow grind. Underneath the calm surface of markets are some extremely concerning trends.
Fundamentally, the financial system has become bogged down in the quagmire of rising interest rates. The root cause – a selloff in longer-dated government bonds and affiliated debt and an ensuing mark-to-market collapse in the assets of vulnerable US lenders – has only worsened.
According to a paper by academics from Stanford and other US universities, “the US banking system’s market value of assets is $2-trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Mark-to-market bank assets have declined by an average of 10% across all the banks, with the bottom fifth percentile experiencing a decline of 20%.”
The implications are concerning.
The US banking sector running on an average of only 10% equity means that a 10% drop in asset values makes the entire system (on a mark-to-market basis) insolvent.
Bank treasurers will doubtless argue that this is no immediate cause for concern. Banks, self-evidently, do not operate on a mark-to-market basis. Given their sticky depositor base, they should be fully capable of holding assets to maturity, so who cares what the market might be valuing them at?
Furthermore, any treasurer appreciates the importance of hedging interest rate risks. However, this (hopefully) momentary insolvency of the US banking sector has some very real consequences.
First, deposit holders are not stupid. The trend of clients withdrawing their deposits from regional US banks and transferring them to money market funds and “systemically important” majors such as JPMorgan and Goldman Sachs has accelerated.
Second, bank runs are not the only threat to financial institutions. Profitability matters. Dwindling deposits mean that banks will have to start paying higher deposit rates to try to retain them. Calls for liquidity will require forced selling in their distressed asset books. This toxic combination will decimate banking profitability, especially among vulnerable banks.
As Rob Armstrong writes in the Financial Times, “the heart attack phase of the banking crisis may be over, as the threat of runs subsides in the face of official support for banks. Now, however, we have to see if any banks are going to die slowly, killed by the cancer of declining profit.”
But perhaps the most concerning effects of the increasingly sclerotic US banking system will be in specific areas of the economy that are most exposed, such as the $5.6-trillion market for commercial property loans.
For commercial real estate in the US already battling lower post-pandemic occupancy, higher interest rates have led to ever lower valuations, creating losses for the regional banks that do most of the lending in this market.
Then, the recent crunch in the financial sector is limiting lenders’ ability to extend additional credit to struggling commercial borrowers, as banks try to offload assets. This is putting further pressure on valuations, as embattled developers are forced to sell into a market already experiencing a glut of empty office space.
Thousands of small and medium-sized banks account for about 70% of so-called commercial real estate loans, according to analysts. The risk of a vicious death spiral in this sector, triggered by rising interest rates, falling property valuations and collapsing banks, is not inevitable – but it is hard to imagine how it could be averted.
This is but one potential next act in the saga playing out across global financial markets. Central bankers demonstrated last week that they are not done hiking rates. Good luck to them in their battle against inflation. Good luck to everyone else in surviving the fallout.