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U.S. regional banks are toppling like dominoes. Small-and-mid-sized lenders are struggling to adjust to rapid interest-rate hikes, and it’s a theme the U.S. has seen before.NOAH BERGER/AFP/Getty Images

Jamie Dimon said it was over, but it isn’t.

On Monday, JPMorgan Chase & Co.’s chief executive tried his best to exude serenity after buying First Republic Bank FRCB for a song, telling investors “this part of the crisis is over.” A few banks had failed, yes, but they were peripheral shocks. “Everyone should just take a deep breath,” he added for emphasis.

The calm lasted two days. By Wednesday, contagion fear was prevalent again. PacWest Bancorp PACW-Q, a small regional lender based in Los Angeles, closed the week down 43 per cent, and Memphis-based First Horizon Corp. lost 38 per cent after mutually agreeing to scrap its takeover by Toronto-Dominion Bank TD-T, citing regulatory hurdles.

Over all, the KBW Nasdaq Regional Banking Index lost 8 per cent of its value this week – and is down 30 per cent since Silicon Valley Bank started to wobble in early March. Save for the early days of the pandemic, the last time the index was this low was 2016.

But at the same time, many major banks around the world are doing just fine – perhaps even thriving – including JPMorgan, Royal Bank of Canada RY-T and Commonwealth Bank of Australia. Some smaller lenders outside the United States are in the same boat. Shares of National Bank of Canada NA-T, a mid-sized lender by U.S. standards, are back above $101, down only 4 per cent from their record high set in late 2021.

What to make of this disjointed chaos? So far, the trauma is very different from the 2008 global financial crisis. Back then, the world’s largest lenders were the most vulnerable because so many had balance sheets full of toxic assets backed by the weak U.S. housing market.

This time around, small-and-mid-sized lenders are struggling to adjust to rapid interest-rate hikes, and it’s a theme the U.S. has seen before. More than 1,000 lenders failed during the Savings & Loan crisis in the 1980s and early 90s. There are many parallels to that era, which means investors could use it for guidance. Just like S&Ls, the banks faring the worst today are those that either rely on traditional lending to drive profits or overextended themselves when deposits were cheap. Sometimes both.

Because Americans were flush with cash from trillions of dollars worth of stimulus payments, they dumped the money into chequing and savings accounts that paid almost no interest. It gave banks virtually free money to lend, and for years it made for nice profits. But once central banks started hiking interest rates around the world in early 2022, the cheap funding dried up.

For the first few months, no one really knew how long the tightening would last because it wasn’t clear just how sticky inflation would be. But by late 2022, it was clear this is a new era, dubbed “higher for longer” – higher rates for longer than expected – and depositors changed their behaviour.

Unprofitable technology companies, for one, started withdrawing deposits because they needed the cash to fund their operations and couldn’t ask a venture-capital fund for more money. Silicon Valley Bank (SVB) had been a major lender to startups, and its deposits began dropping in 2022.

Banking clients have also realized that they are earning next to nothing on their deposits, even though rates are much higher now. At First Republic, which regulators seized and then sold to JPMorgan on Monday, most deposits were in checking accounts that paid next to nothing. Money-market funds, meanwhile, are paying 4.9 per cent – and they invest in ultrasafe, short-term U.S. treasury bills. Since the start of the year, US$600-billion has moved into U.S. money-market funds, a gain of 12 per cent, according to Investment Company Institute. (In Canada, a similar trend is playing out with cash ETFs.)

To help banks that are bleeding deposits, the Federal Reserve set up an emergency lending program for lenders, and it’s been wildly popular. Within two weeks of its creation in mid-March, US$110-billion had been borrowed.

But there’s a trade-off for any lender that uses it. The cost to borrow this money, currently 4.7 per cent annually, is expensive because it tracks the Fed’s benchmark interest rate, which just climbed another 25 basis points this week.

The expensive rate is problematic for banks because the U.S. yield curve is currently inverted – which means longer-term interest rates are actually lower than short-term rates, which is commonly seen before a recession. Banks usually make money by borrowing at low short-term rates, and then lending that money out for longer periods through products such as mortgages.

In late March, Chris McGratty, head of U.S. bank research at Keefe, Bruyette & Woods, summarized the problem in a note to clients: “An upside-down funding base is unsustainable.”

Some banks have exacerbated this problem by investing their excess deposits in securities such as government debt. Although U.S. government bonds are virtually risk-free – which means the money will be repaid in full at maturity – lenders that are bleeding deposits need that money now, yet the value of these bonds in the open market dropped while rates rose. Once investors seized on this problem at SVB, the bank run started.

For many large lenders, profits from divisions such as wealth management and capital markets add financial stability and take the emphasis off of deposits. Many regional banks, though, are bread-and-butter lenders with balance sheets mostly full of mortgages and commercial and industrial loans. Deposits are usually the main source of funding for these loans.

In normal times, an upside-down funding model wouldn’t be the end of the world. Even if banks report some quarterly losses, they all have much more capital – effectively excess cash – to absorb them than they did during 2008.

But in this market, fear outweighs calm and short-sellers that bet against bank stocks are out for blood. First Horizon, for one, always saw the deposit craze in 2021 and 2022 as ephemeral. “We were not willing to take what to us seemed like an inflated deposit base and invest it in assets, securities or otherwise,” chief executive officer Bryan Jordan said on a conference call Thursday.

Investors didn’t care. The second the TD deal died this week, they dumped the stock, even though First Horizon is profitable.

First Republic was in the same boat. The bank made US$269-million last quarter, and 11 megabanks gave it $30-billion in deposits in late March to stabilize its funding model. It didn’t matter. The lender is gone now.

Despite the similarities to the savings and loan crisis, information moves quickly today, and technological advances make it much easier to move deposits. That doesn’t mean a slew of banks will fail, but in the current environment, they’ll have to do more than point to profits and capital as proof of their strength.

Follow Tim Kiladze on Twitter: @timkiladzeOpens in a new window

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