DAVID BUCKHAM: All is not well with US banks

I was privileged to meet Michael Avery earlier this week to discuss the issue of bank failures in the upcoming episode of The Monocle Banking Podcast. The meeting was particularly timely given that Sunday marked the one-year anniversary of the collapse of Silicon Valley Bank (SVB) in what became the third-largest US bank failure yet.

Within seven weeks it was followed by the failure of Signature Bank and First Republic Bank. At the time it seemed unthinkable that such disruptive failures could transpire in an economy as large as the US, especially given the intrusive regulation imposed on banks in the post-Crisis era, and the enormous levels of government fiscal and monetary support simultaneously provided. And yet it did. 

In June last year, when the Federal Reserve released the results of its annual stress test, it assured the public that the US banking system was, in the words of vice-chair for supervision Michael Barr, “sound and resilient”, confirming that banks had more than enough capital to survive even what the Financial Times termed a “doomsday economic scenario”.

However, I have a strong sense that it may have been a pre-ordained decision to find the banking system so, given that just days after the collapse of SVB and Signature Bank the federal open market committee used precisely the same words, stating in its policy statement that “the banking system is sound and resilient”. Only last week was this phrase removed.   

There is no doubt that the Fed’s 2023 stress test was disingenuous. Only the 23 largest banks in the US formed the sample for the stress test, the result of the rollback of the Dodd-Frank Act under the Trump administration in 2018, raising the threshold for testing from $50bn in assets to $250bn in 2018.

Just one demonstration of the disingenuity of the 2023 stress test is found in the fact that 80% of commercial real estate exposure in the US is not held by these 23 banks. When the Fed reported that the banking system was in a good position to weather a simulated “severe global recession”, involving a 40% decline in commercial real estate, 80% of the US’s commercial real estate exposure was thus not tested.

Misleading test

In this “severe global recession”, the problem of unrealised losses on banks’ balance sheets — the very issue that led to SVB’s failure — was eviscerated by the Fed dropping interest rates near to zero in the test scenario. The same institution has raised interest rates 11 consecutive times over the past year-and-a-half. 

Highlighting the misleading nature of the stress test recently, New York Community Bancorp (NYCB) experienced a period of trouble, due predominantly to its purchase of Signature Bank’s assets, possibly at the behest of the New York Federal Reserve. NYCB has accumulated assets of more than $100bn, with a substantial portion of its portfolio comprising New York real estate, which is subject to rent controls, rendering many of properties no longer commercially viable.

Just days ago, NYCB was saved, at least for the time being, by a $1bn cash injection from former treasury secretary Steve Mnuchin, but this came at a cost for existing shareholders since it was particularly dilutive and discounted. 

In contemplating the anniversary of SVB’s failure March 11 marked the close of the Fed’s Bank Term Funding Programme (BTFP), which was established on March 12 2023 — a year ago — to provide emergency liquidity to the banking sector. Through this programme the Fed extended loans to eligible US depository institutions with a term of up to one year, secured by bonds and mortgage-backed securities.

To further prop up banks’ balance sheets, the bonds were priced at their original face value and not at market value, insulating them from interest rate rises. The core purpose of this funding was to ensure that these institutions would be able to meet their obligations to depositors and, in turn, prevent further panic. 

Some commentators have postulated that the Fed’s decision to end the BTFP stems from an aversion to moral hazard. However, the true reason that a continuation of the programme has not been entertained arises from the structure of the interest rate on the BTFP loans.

The BTFP interest rate is calculated based on a market-related one-year overnight index swap rate, which in recent months exceeded the rate offered by the Fed on excess reserve balances, essentially providing opportunities for interest rate arbitrage and the creation of free money, in a monetary system already saturated by multiple rounds of quantitative easing. 

While the Federal Reserve has repeatedly brushed off any scintilla of critique of its management of the monetary system over the past 15 years, making the 2023 banking crisis sound benign, there is in fact something quite menacing about the current state of the US banking system. It should be of grave concern that the Fed is withdrawing its BTFP lifeline, as compromised as it is, when there is more, not less, uncertainty than a year ago.

At some point the Fed will have to stop marking its own homework if the world’s reserve currency is to continue to demand trust from the rest of the world. 

• Buckham is CEO of banking and insurance management consultancy Monocle and author of ‘Why Banks Fail’.