Why Banks Fail and What It Means for the Stock Market?

A lot, if not everything, in the world of finance, is based on trust: trust that the future would be better than the present; trust that a dollar bill would guarantee an equivalent worth of goods and services at a given point in time; and trust that wealth created would be safe, accessible, and transferrable at all times.

So, when events like those unfolding over the past fortnight undermine one or more of the aforementioned collective beliefs, the ensuing risks can quickly become systemic and existential.

On February 24, KPMG signed an audit report giving SVB Financial, Silicon Valley Bank’s parent company, a clean bill of health for 2022. On March 10, federal regulators announced that they had taken control of the bank, which reopened the following Monday as Deposit Insurance National Bank of Santa Clara.

This was the second-biggest bank failure since Washington Mutual’s collapse during the height of the 2008 financial crisis. It was soon followed by the third-biggest, with Signature Bank shuttered by the regulators to stem the fallout from Silicon Valley Bank’s failure.

The resulting crisis of confidence has somehow been contained with an assurance that all insured and uninsured depositors would get their money back, the announcement of a new lending program for banks, and 11 banks depositing $30 billion in the First Republic bank.

However, the contagion risk subsided only after claiming an illustrious victim from the other side of the Atlantic, with UBS agreeing to take over its troubled rival Credit Suisse for more than $3 billion in a deal engineered by Swiss regulators.

Since we are more or less up to speed, let’s look deeper into what can make banks seem unbankable in a little over two weeks.

What is a bank failure?

Banks earn their bread and butter by putting to work the money their depositors entrust with them.

While the money can be invested to acquire assets that generate returns to keep a bank operating, it comes with the obligation to pay its dues on time.
Simply put, depositors should be able to access their money whenever they want and need it. A failed bank fails to ensure that.

How does it happen?

As discussed above, lending financial institutions, such as banks, are also borrowers to their depositors. However, the operating model of banks is based on the belief that they won’t have to pay their depositors all at once.

So, after maintaining sufficient reserves to service its current liabilities, a bank becomes an investment vehicle providing capital to turn the wheels of the modern economy.

However, this model gets foiled when uncertainty and groupthink meet to make fear more contagious than any virus. Depositors, driven by concerns for the safety of their deposits, rush to the exits en masse, turning their fear into a self-fulfilling prophecy. This is called a bank run.

Although SVB was a big bank, its depositor base was relatively concentrated in the geographical region from which the bank derived its name. As the Fed raised interest rates in its efforts to fight the persistent inflation in a red-hot economy, the “ultra-safe” long-term U.S. Treasury securities in which the bank invested its burgeoning deposits suffered significant markdowns.

As the going got tough for the frothier tech companies and venture capital-backed startups amid increased borrowing costs, the bank’s clients began to dip into their deposits. The bank had to convert its paper losses into real ones to meet its payment obligations. On March 8, SBV announced that it booked a $1.8 billion loss after selling some of its investments to cover increasing withdrawals.

As Moody’s downgraded SVB Financial, panic spread through texts and social media. Depositors began pulling their money out of the bank. The consequent snowball effect overwhelmed the bank with an attempted withdrawal of $42 billion by the time the bank closed for business on March 9.

What does it mean for stocks?

Given how modern finance is structured, banks play an instrumental role in the way we hold and manage our money. So, when the reliability of the banking system is compromised, it justifiably sends shockwaves across the entire economy, and, by extension, the ripples get reflected in the stock market too.

As SVB Bank’s stock crashed after the disclosure of a $1.8 billion realized loss from the sale of marked-down securities and the announcement of plans to raise $2.25 billion by selling a mix of common and preferred stock, the panic wiped out a combined $52 billion in the market value of JPMorgan Chase, Bank of America, Wells Fargo and Citigroup.

Going forward, the fate of the stocks would depend on the effectiveness of the measures, such as the lending program, in keeping banks well-capitalized for unpredictable but inevitable shocks in the weeks, months, and years ahead.

What does it mean for the overall market?

In his speech after the recent FOMC meeting, Federal Reserve chair Jerome Powell acknowledged the stresses banks have lately come under. He also suggested that tightening financial conditions arising from stringent lending decisions by banks to preserve liquidity could induce a credit crunch.
Since tight lending would have the same effect as interest rate hikes, the banking crisis, if managed and contained effectively, could be the mixed blessing that convinces the central bank to soften its stance and achieve the elusive “soft landing.