Investment advice: Protect yourself from future bank failures

Will you be impacted by future bank failures? Silicon Valley Bank failed on March 10, 2023, and Signature Bank failed on March 12. The Federal Deposit Insurance Corporation (FDIC) took over both banks quickly and insured all deposits, even those exceeding the FIDC insurance limits. First Republic Bank was closed on May 1 and was purchased by JP Morgan Chase (with guarantees provided by the U.S. government).

You were likely not impacted by these bank failures, so why should you care? Many banks in the U.S. are still in danger of failing.

There were many factors involved in the bank failures, but I will focus on only three:

1. What caused the “run on the bank”?

Regulators were not expecting a “run on the bank,” which was eerily similar to the events of the 1930s during the Great Depression. Although there were bank failures during the 2008 financial crisis, they were very different from what occurred at Silicon Valley Bank (SVB) on March 10, 2023. SVB’s target market was the technology industry and start-ups, and 94 percent of the deposits were over the FDIC insurance limits.

Twitter spread the word rapidly that SVB was in financial peril, and technology advancements in recent years allowed customers to use online banking and smartphone apps to move their accounts instantaneously while sitting at home in their pajamas. And they did. Customers knew their account balance exceeded the FDIC limits, and fear of losing their money was a major factor in their impulsive behavior. A wait-and-see attitude did not seem prudent.

On Thursday, March 9, 2023, $42 billion was transferred from SVB, and on Friday, March 10, customers were attempting to move an additional $100 billion. Total deposits were reportedly $173 billion.

A major factor in the bank’s financial troubles was the increase in interest rates by the Federal Reserve that began in March 2022. In just 14 months the Federal Reserve raised short-term interest rates from 0 to 5 percent, in its effort to reduce inflation. Federal Reserve Chairman Jerome Powell’s stance during 2021 that inflation was “transitory” turned out to be inaccurate, and the interest rate increases have been swift.

The technology industry (which was a large part of SVB’s customer base) grew rapidly during 2021, and bank deposits tripled in only three years. This created a challenge for the bank’s executives to determine how to invest the new money (reserves). They chose to invest significant amounts in long-term treasury notes and mortgage-backed securities in 2021 and early 2022. These were considered safe, and the bank was attempting to earn a higher yield than if they had limited their purchases to short- or intermediate-term fixed-income investments.

If the Federal Reserve did not raise interest rates, holding much of the bank’s reserves in long-term bonds would not have been a problem. However, as interest rates increased (March 2022 – May 2023), the current market value of the bonds decreased significantly. This caused what is termed “unrealized losses,” which results from the discrepancy between the maturity value of the long-term bonds and the current market value. If the bank could hold the bonds until maturity, then the current market value would be irrelevant. However, if many customers decided to withdraw their money, the bonds would have to be sold early, triggering the losses.

Regulators were aware of the unrealized losses in the bank’s reserves, but they severely underestimated the risk. In an article dated November 11, 2022, Jonathan Weil of The Wall Street Journal reported that the market value of bonds held by 24 large US lenders in the KBW Bank Index was 14 percent lower than the maturity value, and some banks had losses as high as 18 percent. By early 2023 the losses were even larger.

The Federal Reserve released an extensive report on the failure of SVB on April 28, 2023, blaming the collapse on mismanagement by bank executives, and lax oversight by Federal Reserve regulators. Greg Becker, CEO of SVB, blamed the bank’s collapse on the rapid increase in interest rates by the Federal Reserve.

Both are correct, but the biggest culprit in my view was the fear-induced run on the bank that led customers to move their accounts so rapidly that regulators or government officials could not slow the momentum or prevent the bank failures. This has repercussions for the entire banking industry, indicating that banks no longer have a “sticky” relationship with their customers. The loyalty that banks relied on from their customers over many decades has disappeared.

2. How do banks invest our deposits?

If SVB had deposits that totaled $173 billion and withdrawals (assuming the March 10 withdrawals were completed) totaled $142 billion, one may assume the bank could have processed the withdrawals, with a whopping $31 billion remaining. This would have been true if the bank was required to keep all the deposits in cash. Of course, that is not the reality of how banks work. See the accompanying diagram that shows how banks invest the deposits they receive from their customer.

Banks hold very little cash. They invest the deposits because they need to earn money to pay their customers, who are now demanding higher returns on savings accounts and CDs due to the Federal Reserve raising short-term interest rates. Banks invest a portion of their reserves in bonds, and they provide loans to customers for home mortgages, car purchases, lines of credit, commercial real estate, and small businesses.

3. What dangers are lurking below the surface?

The unrealized losses on their long-term reserves were a major problem when many customers decided to move their accounts to other banks and investment firms. To generate cash quickly for the withdrawals, the long-term bonds had to be sold. This triggered the unrealized losses. However, the banks had other problems. Many of the mortgages owned by banks are at low fixed rates (roughly 3 percent) for 15 to 30 years, and the rate for new mortgages is now over 6 percent. A low fixed rate mortgage is valuable for the homeowner, but not for the bank.

Economists are sounding alarms regarding commercial real estate. Several large cities have reported downtown office occupancy rates are less than 50% percent. The owners of the office buildings are not being paid rent for unoccupied offices, which may lead them to default on their commercial loans. On June 7, 2023 Treasury Secretary Janet Yellen said, “I do think that there will be issues with respect to commercial real estate.” Goldman Sachs estimated that banks with less than $250 billion own approximately 80 percent of mortgages for commercial real estate. Federal Reserve Chairman Powell said on June 14, 2023, “There’s a substantial amount of commercial real estate in the banking system; a large part of it is in smaller banks. These risks are currently “unrealized,” but banks are facing headwinds from many directions.

How to protect yourself

The best way to protect yourself is to keep your deposits at any one FDIC-insured bank below the FDIC insurance limits. For an individual account, the limit is $250,000; for a joint account, it is $500,000. The FDIC limit may be higher, depending on how your accounts are titled. Find out the details at FDIC.gov.

Do not assume the FDIC will insure amounts above the FDIC limits in the future. The FDIC and the US government have received criticism for insuring the full amounts at SVB and Signature Bank and for bailing out Wall Street firms and big banks during the 2008 financial crisis.

If you need to keep amounts of cash that exceed the FDIC limits, divide it among several different FDIC-insured banks. Each bank will provide you with FDIC insurance for the balances in your accounts.

Another strategy is to use a brokerage account to buy “brokered CDs.” These carry the full amount of FDIC insurance for CDs from each bank. For example, you can buy ten $250,000 CDs from ten different banks, (all in your brokerage account), and you would then have $2.5 million in FDIC insurance. Using brokered CDs does not help with savings and checking accounts, but you can build a CD “ladder” using CDs that mature at three months, six months, one year, etc. so that a CD matures frequently to match your cash flow needs.

Summing it up

The bank failures were a wake-up call for the banking industry and regulators, and the underlying problems are not easy to fix. JP Morgan Chase CEO Jamie Dimon stated in April “there will be repercussions for years to come.”

The unrealized losses that many banks have on their reserves are a major risk. Bank customers are aware they can move their money rapidly to access higher rates at other banks or investment firms. Potential losses due to defaults on commercial loans are a factor. These risks will likely lead to increased turmoil for small and regional banks going forward, and more bank failures.

Donna Skeels Cygan, CFP®, MBA is the author of The Joy of Financial Security, and her upcoming book Sage Choices After 50. She owned a fee-only financial planning firm in Albuquerque for over 20 years before recently retiring. She welcomes emails from readers at donna@donnaskeelscygan.com. Prior columns are available at donnaskeelscygan.com/insights/.