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A Rapid-Finance World Must Ready for a Slow-Motion Banking Crisis
Though the Fed and FDIC have stopped contagion from SVB for now, smaller banks could face pressure for years to come

By Greg Ip
March 29, 2023 9:00 am ET

In recent decades financial crises have tended to be fast-moving and violent. They usually revolve around a handful of companies or countries, and often climax over a weekend, before Asian markets open.

That template is grounds for hope that the worst of the current turmoil may have passed with the collapse of Silicon Valley Bank and Signature Bank and the forced merger of Credit Suisse with UBS Group AG this month, as well as the federal backstops implemented in response to these events.

But another template is also possible: the corrosive, slow-motion crisis. SVB collapsed because of a confluence of structural factors that to a lesser extent afflict many institutions. That could force many banks in coming years to shrink or be acquired, a process that also hampers the supply of credit.

In decades past, banking crises around the world routinely took years to unfold. From 1980 to 1994, roughly 3,000 mostly small U.S. savings and loan institutions and banks were closed or bailed out.

The S&L crisis began when the Federal Reserve pushed interest rates up sharply to combat inflation. S&Ls and banks found themselves squeezed between low-yielding loans and rising rates on deposits and money-market funds.

The current episode began similarly. From 2008 through 2021, the Fed kept interest rates near zero. Banks boosted their holdings of government and federally backed mortgage bonds in search of yield. When rates began to rise sharply in 2022, those bonds’ market values plummeted. While those losses were especially acute at SVB, it was hardly alone. Stanford University finance professor Amit Seru and three co-authors recently estimated that 11% of U.S. banks, around 500 in total, suffered larger percentage losses on their assets from higher interest rates than SVB.

Still, in past crises defaults were ultimately more important than interest rates. In the 1980s, commercial real-estate loans were pummeled by recession, overbuilding and the collapse in oil and gas prices. Mexico and other emerging economies defaulted on loans to money-center banks. In 2007-2009, subprime mortgages and related derivatives went bad.

The credit picture looks less worrisome now. S&P Global Ratings calculates 86% of banks’ securities were federally backed in the third quarter of 2022, compared with 71% in 2008 (the remainder are corporate bonds, private mortgage and asset-backed securities).

To be sure, banks have until recently benefited from unusually low credit losses because the value of collateral such as cars has been so elevated, notes Chris Whalen of Whalen Global Advisors LLC, a finance and banking consultancy. Those losses are going to mount. Small banks in particular are exposed to commercial real estate.

Still, while a recession would boost defaults, it might also result in falling interest rates, which would lift the value of bond portfolios. In fact, total unrealized losses shrank in the last quarter of 2022 as bond yields eased.

Compared with the past, the bigger problem for banks isn’t the asset side of their balance sheets but the liability side.

That is in part due to the fiscal and monetary-policy response to the pandemic. The Federal Reserve restarted purchases of bonds, and the Treasury sent big stimulus and other relief payments directly to household bank accounts. As a result, deposits ballooned. The ratio of bank loans to deposits fell to a 50-year low of around 60% in September 2021, Moody’s Investors Service said in a report.

While a growing share of banks’ deposits were uninsured, they were assumed to be relatively “sticky,” or less prone to flee than other types of wholesale funding. But social media and smartphone banking apps seem to have changed that.

While online banking has been around for decades, it has become much more popular and powerful. The share of bank customers who use internet or mobile banking has jumped from 52% in 2017 to about 66% in 2021, according to the Federal Deposit Insurance Corp.

This didn’t matter when interest rates were near zero and depositors had little reason to look for higher-yielding alternatives. But when the Fed lifted rates toward 4% last year, savers started to move: deposits have been shrinking for the past year, propelled in part by the Fed reversing its bond purchases, soaking up some of banks’ excess reserves and deposits.

Jim Bianco of Chicago-based Bianco Research noted that in 2007 failing British lender Northern Rock’s website crashed, forcing customers to visit branches to withdraw their money. No such problems cropped up this time. SVB’s deposit outflows reached a staggering $42 billion on March 9 and were on track to hit $100 billion the next day, Michael Barr, the Fed’s vice chairman for banking supervision, told Congress on Tuesday.

Mr. Bianco predicted such flows will become even more frictionless with the launch in July of FedNow, a real-time payments service operated by the Fed through which bank customers can transfer funds instantly, instead of waiting for the transaction to settle.

“Deposit behavior has now changed—it’s going to be much more sensitive to market vs deposit rates,” Mr. Bianco predicted.

This will likely hurt smaller and regional lenders more, because depositors will reflexively move their money to banks they think are too big to fail. Indeed, in the week ended March 15 smaller banks lost $120 billion in deposits while the largest gained $66 billion, the Fed has reported. “I have real concerns about the deposit franchise value at midsize banks,” Daleep Singh, a former economic adviser to President Biden who is now chief economist at PGIM Fixed Income, told the Journal last week. Savers or small businesses with deposits above the federally insured maximum of $250,000 would rationally move that money to “safer alternatives,” he said.

When Moody’s downgraded the credit-rating outlook of the U.S. banking system earlier this month, it too cited the threat to many lenders’ deposits: “Banks with substantial unrealized securities losses and with non-retail and uninsured US depositors may…be more sensitive to depositor competition or ultimate flight, with adverse effects on funding, liquidity, earnings and capital.” High interest rates will add to these pressures until inflation returns to the Fed’s 2% target, it said.

Unless federal insurance is extended to all deposits, this suggests small and medium-size banks could be in for a prolonged period of pressure on their deposits, which could in turn force them to be acquired, or limit their lending. It won’t be a crisis in the usual sense of the word. But the end result may be the same.

Write to Greg Ip