What do PacWest Bancorp, Western Alliance Bancorporation, Zions Bancorporation, and Comerica Inc all have in common?
Their stocks all cratered in March, and have not recovered. If you have clients with large positions in these, or other banks, you may want to consider a tax-efficient way for your clients to reduce their risk. Request a free Advisor Guide here.
The stocks were hit, and remain under pressure, in large part because of investors’ fear that the banks may again become victims of a bank run.
Press reports discussing the potential for a bank run focus on the condition of these, and other, banks’ balance sheets. But in the modern world, any bank, regardless of its balance sheet, is the potential victim of a bank run.
That’s because bank runs are a feature, not a bug, of the modern banking system.
Perhaps “feature” is not exactly the right term. But bank runs — or the potential for bank runs — are an inherent characteristic of the system. The system, as it currently works (and is “designed” to work) is inherently unstable.
That’s because banks rely on deposits which can be withdrawn at any time.
Deposit vs. Bailment: you don’t actually own the money in your bank account
Banks often offer free checking and savings accounts, but rarely offer free safe-deposit boxes.
Safe-deposit boxes represent bailments, and bank accounts do not. A bailment means that the owner of property retains ownership over that property. So people who place property, even cash, in a safe-deposit box retain ownership of that property. The bank cannot legally lend out the contents of your box, and banks don’t lend box contents.
In contrast, when you deposit your money in a bank account, technically the money is no longer yours. Instead, you become a creditor of the bank. You are lending to the bank, and the bank is borrowing from you. The bank is legally free to lend out “your” money in whatever way (subject to regulatory rules) it sees fit.
Deposits and duration risk
Commercial banks fund themselves mostly with deposits. The Fed reports that in August 2023 about 80% of banks’ assets were funded with deposits.
On a large fraction of these deposits, the banks promise the depositor that the depositor can withdraw the money either immediately (demand deposits) or on short notice (many time deposits, such as Certificates of Deposit, sometimes called CDs). The average maturity of these deposit liabilities is therefore very short.
But the banks’ assets are mostly long-term loans. Itamar Dreschler and his colleagues estimate that the overall average duration of bank liabilities is about 0.4 years, while the average duration of assets is over ten times as long, at 4.3 years.[1]
Duration is a measure of interest rate risk. A duration of 4.3 means that for a 1% change in interest rates, the value of the asset (or liability) will change by about 4.3%. So, for example, consider a bond that is worth $1,000 with a duration of 4.3. If interest rates rise by 1%, the value of that bond (everything else equal) will fall by about $43.
How Much Have Banks Been Hurt?
From the record low interest rates in 2020, the interest rate (yield) on the 5 year US Treasury Note has risen by about 4%.
That allows us to make a quick and dirty calculation about how much the interest rate rise has cost the US banking system. The Federal Reserve reports that total bank equity peaked in the 4th quarter of 2021 at $2.35 trillion. Total bank assets were roughly $22.5 trillion. If we apply the 4.3 year duration to that entire $22.5 trillion of assets, we estimate that the loss in market value has been roughly 4.3 (the duration of the assets) times 4 (the amount that interest rates have risen) times the $22.5 trillion of assets. That’s a loss of $3.5 trillion.
There are a couple of mathematical reasons to believe that the actual loss is less. These are the fact that we ignored the interest banks earned during the three years, and the mathematical fact that naïve duration is a linear estimation, and bond prices don’t change linearly for large changes in interest rates. Here’s an example. Suppose that you have a bond with a duration of 20,[2] and interest rates rise 5%. The linear application of duration would suggest that the bond has to lose 100% of its value, but obviously, that doesn’t happen.
Stanford’s Amit Seru[3], and colleagues, have estimated that the actual loss is about $2.2 trillion.
If that is right, the banking industry as a whole has less equity than reported, and may even have virtually no equity. The Fed reported that US banks have total equity of $2.2 trillion as of the second quarter of 2023.[4] The industry as a whole might be insolvent. Professor Seru was quoted by the UK newspaper Telegraph saying, “Thousands of banks are underwater…. A lot of the US banking system is potentially insolvent.”[5]
“Held to Maturity”
If the above reasoning is correct, then why don’t we hear more about the potential looming banking crisis?
One reason might be a regulatory rule called “held to maturity.” Banks are permitted to classify assets as “held to maturity.” Assets classified as held can be counted for accounting purposes at their original cost. So banks don’t have to show on their financial statements the losses of market value.
If you think held to maturity isn’t quite right, you’re not alone. Sandy Peters, who is a CPA and a CFA, is on the same page as the CFA Institute in arguing that the accounting standard should be fair market value, not, as she calls it “Hide till Maturity.”[6]
Deposits, and Runs
Held to Maturity losses are still real losses. If a bank needs to repay depositors, it may need to sell those assets; and if the assets are sold, they will be sold at market value, not the much higher cost value.
Remember that while the duration of the banks’ assets is 4.3 years, the duration of the liabilities – mostly deposits – is only 0.4 years. Depositors have been promised that they can have their money back very soon, but the regulators have been promised that the bank won’t sell the “held to maturity” securities. So what gives?
If depositors get at all nervous, they might –completely rationally — ask the bank for their deposits back.
That is what happened to Silicon Valley Bank, and several other banks earlier in the year. The bank disclosed in a footnote that the value of its held-to-maturity portfolio had fallen significantly. Some large depositors noticed and decided to be on the safe side and withdraw their deposits. That led other depositors to similarly request withdraws. The withdrawals quickly led to a run.
Asset-Liability Mismatch
Because banks habitually fund short (e.g. average duration of 0.4 years) and invest long (e.g. average duration of 4.3 years), banks are always exposed to the risk not only of interest rate increases, but also to the risk of a run.
Typically, a large fraction of a bank’s assets are in loans that are not liquid, while most of their liabilities are deposits that can legally be withdrawn at any time. That is, the banks predictably cannot pay all depositors, despite having promised all (or most) depositors that they can have their money back at any time.
Depositors know that banks can’t repay all depositors if all depositors want their money back. Because banks pay withdrawals in the order withdrawals are requested, informed and rational depositors want to be near the front of the line to have the best chance of getting their money back before the bank runs out of liquidity. Thus, although no depositor has an incentive to start a run, as soon as a depositor either learns of a run or believes one is imminent, the rational action is to move quickly to withdraw deposits from the bank.
Note that a bank does not have to be insolvent (i.e. liabilities greater than assets) for a run to be rational.
Big Banks Not Exempt
Notice that there is nothing in the economics of asset/liability mismatches or bank runs that renders big banks immune to such problems. “Too big to fail” is a political concept, not an economic one. And even if depositors in “Too big to fail” banks are protected, it does not follow that shareholders will be protected. Indeed, shareholders are likely to be very exposed. For example, the KBW Nasdaq Bank Index lost nearly 90% of its value in less than 2 years between 2007 and 2009.
If you have clients with large holdings of bank stock (pretty much any bank), and you think that those clients might want to diversify, you might want to consider a Stock Diversification Trust, which can allow your clients to sell, reduce risk, diversify, and avoid capital gain tax. Call or email Connor Barth (703) 437-9720 or [email protected] or click here to request an Advisor Guide.
[1] Itamar Drechsler, Alexi Savov & Philipp Schnabl, Banking on Deposits: Maturity Transformation without Interest Rate Risk, NBER Working Paper 24582, January, 2020.
[2] The US Treasury 30 year at 2% yield has a duration of about 22
[3] Monetary Tightening and U.S. Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs? April 5, 2023. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4387676
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