Silvergate Shows What May Happen If Community Banking Crisis Arrives
Bank failures in the U.S. are rare because of the strength of the regulatory system, and the U.S. … [+] banking system is widely regarded as a leader in safety and security, There are stresses inherent in the system, and the recent rise in interest rates has revealed banks that may be in need of additional capital. The Federal Reserve is aware of the problem and in December they hosted an “Ask the Fed” webinar titled “A Discussion of Unrealized Losses at Community Banks in a Rising Interest Rate Environment.”
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A preferred bank of the cryptocurrency industry, Silvergate, managed through a liquidity crisis and incurred substantial realized losses. They are a high profile example of the problems that may be hiding in the balance sheets of community banks, and under high stress situations other institutions may not survive.
The U.S. banking system is widely regarded as a leader in safety and security, and the Federal Deposit Insurance Corporation (FDIC) is quite rightly proud that “since the start of FDIC insurance on January 1, 1934, no depositor has lost a penny of insured funds as a result of a failure.” At the end of September, 2022 there were 4,746 institutions insured by the FDIC, 96.1% of those banks were profitable, and the FDIC designated only 42 “Problem Institutions.”
Lurking beneath the surface of the seemingly healthy industry are problems resulting from the 2022 rise in interest rates. The actions of the Federal Reserve to increase interest rates appear to have caught some banks off-guard, and there are a number of financial institutions that have suffered material unrealized losses. In a December institutional research report from PNC Financial Institutions FISI Group (PNC), they wrote that the Federal Reserve estimated there are 500 banks that require further analysis.
Tangible Common Equity
A common measure of the health of a bank is the TCE Ratio — Tangible Common Equity (TCE) divided by Total Assets (TA). TCE is calculated by subtracting intangible assets (such as goodwill) and preferred equity from the book value of a bank, and to be fair, TA also excludes intangibles. The TCE Ratio is one measure of a financial institutions ability to absorb potential losses, and in an economic downturn, a bank relies upon the TCE to provide a sufficient buffer to offset negative events.
The 500 banks that may be approaching problems have TCE Ratios below 5%, and that is the threshold level being used by the Federal Reserve to determine if further investigation and action is warranted.
While it is good news that the Fed is aware of the problems and that along with the other regulatory agencies they are already working with the banking industry before a crisis manifests, the extent of the problem may be larger than just those 500 banks.
Banks Invest In Bonds
Banks seek to hold liquid funds in excess of the requirements needed to fund loans, and they invest the money and earn interest in what is termed a liquidity portfolio. In normal market conditions, the interest rate paid on longer term instruments such as ten- and twenty-year bonds exceeds the rate banks can obtain by investing in shorter term notes or depositing cash overnight in the Fed, and so banks allocate a portion of their liquidity portfolio to bonds.
Banks can choose how they account for the bonds they purchase. If a bank intends to keep the bond all the way to the repayment date, then the bank may decide that they do not wish to have their profit and loss impacted by any fluctuations in the market prices for that bond. The bank will then place the bond into a “Hold-to-Maturity” portfolio, and price changes from market factors do not show up in the accounting statements. The alternative is for the bank to place the bond within the “Available-For-Sale” (AFS) portfolio, and all price changes flow into the accounting statements.
When interest rates recently went up, the bond prices went down. Potentially worse for banks, the longer-term bond fell further relative to short term bonds for a given change in interest rates. So banks that owned bonds recorded losses in their AFS bond portfolio and their TCE was reduced as the losses moved into the bank accounting records.
Sometimes it is argued that these losses are not “real” and that the bank will earn it back over time. These fallacies are believed because a bond is repaid par value (the face value) at maturity. For example, U.S. government bonds are always paid 100% at maturity, and hence if held to the end date the bondholder always receive full value regardless of the value of the bond at any point prior to maturity. While that is factually correct, the reality is that at any time prior to maturity the bond will have a price set by the market, and that price may be substantially higher or lower than the par value.
Banks May Have Negative Tangible Common Equity
PNC estimated that within the Fed identified set of 500 banks, there are approximately thirty with negative TCE. If those 30 banks were liquidated today, for whatever reason, the FDIC insurance fund would take a loss to cover a portion of the customer deposits.
The full extent of the problem is still hidden because the analysis does not include the consequences from the “Held-to-Maturity” (HTM) portfolios. For those banks that allocated bonds to the HTM portfolio, the true bank value is less than the TCE because the decrease in bond market valuations is not recorded in the accounting and TCE. Worse yet, any bank that requires liquidity and liquidates part of the HTM loan portfolio would realize those losses potentially leaving the bank undercapitalized.
Silvergate Bank Realized Losses
Consider the case of Silvergate Bank. In the fourth quarter of 2022 the bank faced an outflow of deposits from crypto currency customers and sold $5.2 billion of securities from their liquidity portfolio. Signature realized a loss of $718 million (including the impact of related derivatives). That loss did not originate from their core operating businesses but rather resulted from the sale of bonds prior to maturity.
Silvergate cleaned out most of the unrealized losses in their bond portfolios in that sale, and they already faced the consequences. At year end they held $5.6 billion of debt securities, and that balance included only $0.3 billion of unrealized losses.
There is always the possibility that banks will need to sell bonds from its liquidity portfolio – that is why they have a liquidity portfolio in the first place. There are far more banks that could be highly stressed by a liquidity event because they do not have sufficient capital, and those banks are hidden by the treatment of the HTM bonds.
The Fed Knows The Problem
In December the FED hosted an “Ask the Fed” webinar titled “A Discussion of Unrealized Losses at Community Banks in a Rising Interest Rate Environment.” The regulatory agencies are aware that the problem of the “hidden losses” and they will be working with undercapitalized banks to shore up their balance sheets. Expect to see heightened activity in the community banking space with increased fundraising and merger and acquisitions. Perhaps this time through the vigilance of the regulators they will be able to head off a major banking crisis before it happens.
The author is a shareholder of Silvergate Capital SI Corporation, the NYSE listed holding company for Silvergate Bank. The author’s company is a client of PNC Capital Markets LLC.
