Wall Street Is Betting the Regional Bank Crisis Isn’t Over Yet

“All of a sudden we are raising rates, faster than last time and to a higher level,” said Philipp Schnabl, a professor at New York University who co-wrote a paper on the bank turmoil. “Now is a question of people waking up – are they seeing something on Twitter, reading about it, and maybe changing their behavior?” he said, referring to depositors pulling out their cash.

One major bank index dropped 4.5% Tuesday to the lowest since late 2020 while trading in PacWest Bancorp and Western Alliance Bancorp was halted at one point. Both extended losses in pre-market trading Wednesday following declines of 28% and 15%, respectively, a day earlier. Meanwhile, two- and 10-year yields also dropped further as investors rushed for havens and jobs data pointed to a softening labor market.

Stresses in the banking sector are a headache for Federal Reserve officials meeting this week, as they weigh financial stability concerns against still stubborn inflation, as shown in data released Friday. While regulators are mulling a broadening of deposit insurance, no changes have yet been announced — one reason for the market plunge on Tuesday.

Meanwhile, depositors are waking up to the higher-yielding alternatives outside of bank offerings. Regulatory data show the average US savings rate stands at just about 0.39%, compared with a fed funds rate of nearly 5%.

Until two months ago, the deposit beta — which measures how sensitive deposit rates are to changes in the market rate — was lower than in previous rate cycles at about 0.2. That meant that banks could pass onto savers just a fifth of the policy-rate move, according to Itamar Drechsler at the University of Pennsylvania and Schnabl and Alexi Savov at NYU. The average during rising-rate periods historically is about 0.4.

That’s why rate hikes aren’t entirely bad news for banks. Even as long-term assets slide, they can generate big profits thanks to sticky — and cheap — deposits. In fact, in the academics’ calculation, based on a deposit beta of 0.2, the increase in value from the deposit franchise has roughly equaled asset losses in this cycle.

But that moat erodes fast when the deposit beta starts rising and if uninsured depositors panic and pull their cash out. And there’s a growing fear that the era of banking apps means it’s easier and faster than ever to make withdrawals, raising the chance of a stampede.

“It looks like the deposit beta could rise quite a bit and maybe even double and still only really get back to their historical norm,” said Savov. “The question about social media and fintech and so on is about whether they might go beyond that.”

US bank deposits dropped at the fastest pace on an annual basis since 1981 in the last three months of 2022 and shrank by roughly a similar clip last quarter. While deposit betas may still be historically low, Fed researchers noted they have recently been rising much faster compared with previous rate-hike cycles.

Heightening the risks, banks are now sitting on about $1.84 trillion of unrealized losses after rate hikes pummeled the value of their debt holdings, according to the latest projection from four other economists who earlier wrote a blockbuster paper on the crisis. In research last month, they estimate that a 10% default rate on commercial real estate loans – similar to what was seen during the financial crisis – would hit banks with another $80 billion of losses, leaving some vulnerable to a run by uninsured depositors.

While that might seem relatively small, it’s another source of pressure after a year of monetary tightening eroded banks’ capital buffer, wrote Erica Jiang at the University of Southern California, Gregor Matvos at Northwestern University, Tomasz Piskorski at Columbia University and Amit Seru at Stanford University. Exposure to offices has come under scrutiny lately on fears a lasting shift to remote working combined with rate hikes will fuel widespread defaults.

“Even if interest rates went to 2.5% and miraculously inflation went down, this issue still lingers,” Seru said. “I wouldn’t say we are all out of the woods here.”

Until Tuesday, markets appeared to be looking beyond banking turmoil. Only five of 38 non-currency assets tracked by Deutsche Bank moved more than 3% in April, the least since the pandemic. By last Friday, a gauge of Treasury volatility had returned to levels seen before SVB’s demise while the equivalent for the S&P 500, known as the VIX, reached the lowest since late 2021.

Meanwhile, the latest weekly Fed data show an uptick in both bank lending and deposits — supporting the view that it’s not a full-blown crisis yet.

But there are incipient signs of tightening credit conditions. Emergency loans to banks rose last week for a second straight week and a Fed survey reports firms have strengthened lending standards. Bankruptcies are on the rise and banks that reported quarterly results last month said they boosted provisions on bad consumer loans to levels not seen since the early days of the pandemic.

“There are a lot of signs telling us the US banking system is in distress,” said Piskorski at Columbia. “We might want to close our eyes and pretend nothing’s happened, but the signs are already there.”

Bloomberg News provided this article. For more articles like this please visit bloomberg.com.

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