https://www.economist.com/finance-and-economics/2023/03/16/how-deep-is-the-rot-in-americas-banking-industry

"Post-financial-crisis regulations were supposed to have stuffed banks with capital, pumped up their cash buffers and limited the risks they were able to take. The Fed was meant to have the tools it needed to ensure that solvent institutions remained in
business. Critically, it is a lender of last resort, able to swap cash for good collateral at a penalty rate in its “discount window”. Acting as a lender of last resort is one of any central bank’s most important functions. As Walter Bagehot, a
former editor of The Economist, wrote 150 years ago in “Lombard Street”, a central bank’s job is “to lend in a panic on every kind of current security, or every sort on which money is ordinarily and usually lent.” That “may not save the bank;
but if it do not, nothing will save it.”

The Fed and Treasury’s interventions were the sort which would be expected in a crisis. They have fundamentally reshaped America’s financial architecture. Yet at first glance the problem appeared to be poor risk management at a single bank. “Either
this was an indefensible overreaction, or there is much more rot in the American banking system than those of us on the outside of confidential supervisory information can even know,” says Peter Conti-Brown, a financial historian at the University of
Pennsylvania. So which is it?

To assess the possibilities, it is important to understand how changes in interest rates affect financial institutions. A bank’s balance-sheet is the mirror image of its customers’. It owes depositors money. Loans people owe it are its assets. At the
beginning of 2022, when rates were near zero, American banks held $24trn in assets. About $3.4trn of this was cash on hand to repay depositors. Some $6trn was in securities, mostly Treasuries or mortgage-backed bonds. A further $11.2trn was in loans.
America’s banks funded these assets with a vast deposit base, worth $19trn, of which roughly half was insured by the fdic and half was not. To protect against losses on their assets, banks held $2trn of “tier-one equity”, of the highest quality.

Then interest rates leapt to 4.5%. SVB’s fall has drawn attention to the fact that the value of banks’ portfolios has fallen as a result of the rise in rates, and that this hit has not been marked on balance-sheets. The fdic reports that, in total,
America’s financial institutions have $620bn in unrealised mark-to-market losses. It is possible, as many have done, to compare these losses with the equity banks hold and to feel a sense of panic. In aggregate a 10% hit to bond portfolios would, if
realised, wipe out more than a quarter of banks’ equity. The financial system might have been well-capitalised a year ago, so the argument goes, but a chunk of this capitalisation has been taken out by higher rates.

The exercise becomes more alarming still when other assets are adjusted for higher rates, as Erica Jiang of the University of Southern California and co-authors have done. There is, for instance, no real economic difference between a ten-year bond with a
2% coupon and a ten-year loan with a fixed 2% interest rate. If the value of the bond has fallen by 15% so has the value of the loan. Some assets will be floating-rate loans, where the rate rises with market rates. Helpfully, the data the researchers
compiled divides loans into those with fixed and floating rates. This allows the authors to analyse only fixed-rate loans. The result? Bank assets would be worth $2trn less than reported—enough to wipe out all equity in the American banking system.
Although some of this risk could be hedged, doing so is expensive and banks are unlikely to have done much of it.

But as Ms Jiang and co-authors point out, there is a problem with stopping the analysis here: the value of the counterbalancing deposit base has not also been re-evaluated. And it is much, much more valuable than it was a year ago. Financial institutions
typically pay nothing at all on deposits. These are also pretty sticky, as depositors park money in checking accounts for years on end. Meanwhile, thanks to rising rates, the price of a ten-year zero-coupon bond has fallen by almost 20% since early 2022.
This implies the value of being able to borrow at 0% for ten years, which is what a sticky, low-cost deposit base in effect provides, is worth 20% more now than it was last year—more than enough to offset losses on bank assets.

The true risk to a bank therefore depends on both deposits and depositor behaviour. When rates go up customers may move their cash into money-market or high-yield savings accounts. This increases the cost of bank funding, although typically not by all
that much. Sometimes—if a bank runs into severe difficulties—deposits can vanish overnight, as SVB discovered in ruinous fashion. Banks with big, sticky, low-cost deposits do not need to worry much about the mark-to-market value of their assets. In
contrast, banks with flighty deposits very much do. As Huw van Steenis of Oliver Wyman, a consultancy, notes: “Paper losses only become real losses when crystallised.”

How many banks have loaded up on securities, or made lots of fixed-rate loans, and are uncomfortably exposed to flighty deposits? Insured deposits are the stickiest because they are protected if things go wrong. So Ms Jiang and co-authors looked at
uninsured cash. They found that if half of such deposits were to be withdrawn, the remaining assets and equity of 190 American banks would not be enough to cover the rest of their deposits. These banks currently hold $300bn in insured deposits.

The newfound ability to swap assets at face value, under the Bank Term Funding Programme, at least makes it easier for banks to pay out depositors. But even this is only a temporary solution. For the Fed’s new facility is something of a confidence
trick itself. The programme will prop up struggling banks only so long as depositors think it will. Borrowing through the facility is done at market rates of around 4.5%. This means that if the interest income a bank earns on its assets is below that—
and its low-cost deposits leave—the institution will simply die a slow death from quarterly net-interest income losses, rather than a quick one brought about by a bank run.

This is why Larry Fink, boss of BlackRock, a big asset-management firm, has warned of a “slow-rolling crisis”. He expects this to involve “more seizures and shutdowns”. That high interest rates have exposed the kind of asset-liability mismatch
that felled SVB is, he reckons, a “price we’re paying for decades of easy money”. Mr Conti-Brown of UPenn points out that there are historical parallels, the most obvious being the bank casualties that mounted in the 1980s as Paul Volcker, the Fed�
�s chairman at the time, raised rates."

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