Why the US banking crisis has investors worried

Concerns are swirling about a deposit flight and lack of asset diversification among smaller lenders, experts say

US banks have remained resilient across market cycles and the fallout is unlikely to be a system-wide problem, experts say. AFP

Possibly the scariest thing about this year’s banking crisis in the US is that nobody knows how bad it is going to get, which means investors have nobody to turn to for advice or reassurance.

The slow-rolling meltdown is liable to make a mug of anybody who suggests they know what happens next, as JP Morgan Chase chief executive Jamie Dimon discovered last week.

JP Morgan has been busily hoovering up failed banks in the US, to the gratitude of regulators, and after its latest takeover last Monday, Mr Dimon declared that this part of the crisis is over and “for now, everyone can take a deep breath”.

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Whether he believed that or was simply trying to boost confidence at a troubled time, only Mr Dimon knows.

The same applies to US Federal Reserve chair Jerome Powell, who claimed the US banking system was “sound and resilient” shortly before shares in US regional lenders PacWest Bancorp and Western Alliance Bancorp collapsed.

Another scary thing about today’s banking meltdown is how similar it is to the last one. People kept saying that was over, too, only for it to go from bad to worse.

In May 2008, two months after investment bank Bear Stearns went bust, then US treasury secretary Hank Paulson assured The Wall Street Journal that “the worst is likely to be behind us”. It turned out to be right in front of us instead, as Lehman Brothers failed in September.

In another parallel, JP Morgan bought Bear Stearns for $1.4 billion in 2008 and spent another $1.9 billion on Washington Mutual’s assets that September.

The world's largest bank has just got even bigger after taking over First Republic, in a deal negotiated by regulators.

Yet, there is one major difference. While the last crisis was pinned on greedy bankers serving up complex and risky products such as mortgage-backed securities and collateralised debt obligations, this time bankers are being punished for investing in the world’s favourite safe haven, US government bonds, known as Treasuries.

Giles Coghlan, chief market analyst, consulting for HYCM, says US banks piled into bonds when yields were low and prices were high, but when the Fed started to increase interest rates, yields climbed and bond prices crashed.

“Many banks have capital tied up in low-yielding Treasury bonds, which means they don’t have the liquidity to buy the new, higher-yielding Treasuries and offer more competitive interest rates to their depositors,” he says.

Many customers pulled their savings to seek a better return elsewhere, accelerating the rate of deposit withdrawals, Mr Coghlan adds.

“This has had a detrimental knock-on effect on bank earnings — demonstrated by the First Republic collapse — and their stock valuations.”

Investors are now wondering which domino will be the next to fall as worries swirl about a deposit flight and the lack of asset diversification among smaller lenders, says Susannah Streeter, head of money and markets at Hargreaves Lansdown.

“The ease of withdrawals in the digital age is causing increased nervousness, given the speed of recent banking collapses.”

Another worry is that PacWest and other banks have invested heavily in commercial property such as apartment blocks, offices and shopping centres, she adds.

This sector is also vulnerable to rising interest rates, with more than $1 trillion in commercial real estate loans set to mature before the end of 2025. As banks tighten their underwriting, many borrowers may struggle to refinance their debts.

The Fed increased interest rates again last week, lifting the Fed funds rate to a range of 5 per cent and 5.25 per cent, while the European Central Bank also increased its main policy rate to 3.25 per cent and warned of more to come.

Each interest rate increase piles more pressure on banks and threatens financial stability at the same time that sliding oil prices raise recession fears, warns Fawad Razaqzada, market analyst at City Index and Forex.com.

“The market now thinks there will be no more rate hikes from the Fed and that monetary policy may even be loosened later in the year,” he says.

However, Mr Powell warned that it would take time for inflation to come down and it would not be appropriate to cut rates yet.

The Fed now faces an almost impossible choice between letting inflation rage out of control and triggering a systemic banking meltdown.

Investors are understandably edgy, says Chris Beauchamp, chief market analyst at online trading platform IG.

“Crashes in oil and regional bank stocks are driving a flight to safety trade across the globe and gold is in high demand once again,” he says.

Many investors will be tempted to dump their bank stock holdings and run, says Mr Coghlan, but others will take the opposite view.

“Now could be a great time to buy bank stocks or other companies that have low valuations by mere association to the banking sector,” he says. “Some banks could rebound quickly if depositors stand firm and the banking crisis recedes.”

Watch: US Federal Reserve raises interest rates for 10th consecutive time

It may be safer to stick to the bigger players, says Vijay Valecha, chief investment officer at Century Financial.

"If depositors flee regional banks, big banks will boost their shares of deposits because they're viewed as safer."

Ms Streeter agrees that the big banks have bigger capital buffers and new deposits are further strengthening them.

“They also have much more diversified loan books and the Fed is standing by with funding schemes, which they can draw on,” she says.

She also notes that rising interest rates can be good for banks, as this allows them to increase their net interest margins, which measures the difference between what they pay savers and charge borrowers.

Ms Streeter says we are witnessing a crisis of confidence rather than a systemic collapse, and Mr Valecha agrees.

“US banks have remained resilient across market cycles and this fallout is unlikely to be a system-wide problem especially after JP Morgan, Bank of America and other big players have just reported good quarterly numbers,” he says.

Others are less optimistic. Directly before PacWest plunged, Bill Ackman, chief executive of New York hedge fund Pershing Square, tweeted that the entire US regional banking system was at risk as confidence built over decades has been destroyed in days.

“As each domino falls, the next weakest bank begins to wobble,” he tweeted.

Robert Kaplan, the former president of the Dallas Federal Reserve, echoed his views, warning that “we’re in the early stages, not the late stages” of a banking crisis.

As inflation proves sticky, the Fed and other central banks cannot respond to this crisis like they did the last one, by slashing interest rates to almost zero and pumping out endless monetary stimulus. And that’s the scariest thing of all.