The venture capital world is reeling and regional banks nationwide are feeling the pain after the second and third-largest bank failures in U.S. history took analysts by surprise last week. But we were warned.
In Oct. 2019, Martin J. Gruenberg, a board member at the Federal Deposit Insurance Corporation (FDIC), gave a speech titled “An Underappreciated Risk: The Resolution of Large Regional Banks in the United States” at The Brookings Institution’s Center on Regulation and Markets in Washington, D.C.
He told an audience of scholars and regulators that he hoped to “draw attention to the challenges posed by the failure of a large regional bank,” arguing that the subject of rising risks at these banks “received relatively little attention” in the years after the Global Financial Crisis (GFC) because regulators were so focused on so-called “Global Systemically Important Banks.”
Regional banks, or those with assets between $50 billion and $500 billion, “pose very significant challenges to the FDIC,” Gruenberg said. “Their size, complexity, and reliance on market funding and uninsured deposits would present very substantial risks in resolution, with potential systemic consequences.”
Now, the economy is experiencing the fallout from ignoring Gruenberg’s warning. Both of the banks that failed last week, the start-up-focused Silicon Valley Bank (SVB) and the crypto-focused Signature Bank, were heavily exposed to rising interest rates and credit risk, and their customer deposits were mostly uninsured. At SVB, some 93% of all deposits exceeded the FDIC’s $250,000 insurance limit, according to Bloomberg. The problem of uninsured deposits is widespread. U.S. banks held more than $1 trillion in uninsured deposits at the end of 2022, according to an Insider analysis.
In his speech, Gruenberg went on to detail multiple post-GFC regulatory changes at regional banks that increased risks for depositors and the overall financial system. He noted that in April 2019, the FDIC eliminated the 2014 “liquidity coverage ratio” for banks with assets between $100 billion and $250 billion. That regulation had required all banks to hold enough high-quality liquid assets to fund 30 days of cash outflows. Meanwhile, for banks with assets between $250 billion and $500 billion, the liquidity coverage ratio was lowered to 85% of the previous limit.
“Given the risks associated with the failure of large regional banks, these measures are unwarranted and misguided,” Gruenberg said. “They only increase the challenges posed by the resolution of these institutions and the potential for disorderly failure, and disregard the lessons of the financial crisis.”
The FDIC board member concluded with a warning, arguing that regulators had “an unjustified sense of confidence” that the failure of a regional bank “would not be challenging.”
“I believe the experience during the crisis of a large regional bank failure…illustrates the very real risks a regional bank failure would present,” he said, referring to the economic fallout from the collapse of the regional bank IndyMac in 2008, which cost depositors billions, hurt the local community, and resulted in the “largest loss to the Deposit Insurance Fund in the FDIC’s history.”
“Going forward, I believe that attention to this issue should be a top priority for the FDIC, for the other federal and state bank regulatory agencies, and for the banking industry,” Gruenberg cautioned.
Warning ignored, fallout incoming
The “contagion” among regional bank shares after the collapse of SBV and Signature Bank was pronounced on Monday. The iShares US Regional Banks ETF—which tracks regional banks stocks in the U.S.—cratered 12%, and exchanges were forced to halt trading in dozens of individual regional bank stocks.
Shares of West Coast banks were hurt the most. First Republic saw its stock tank another 50% in mid-day trading on Monday after last week’s 33% drop, while shares of PacWest Bancorp and Western Alliance Bancorp sank more than 20% and 40%, respectively.
Investors’ fear spread to the wider financial services sector as well. Shares of Bank of America dropped over 3%, Wells Fargo was down more than 5%, and Charles Schwab cratered 8%. The repercussions of the banking sectors’ fragility will go well beyond the stock market, however.
Richard Saperstein, chief investment officer at the investment firm Treasury Partners, told Fortune that he expects “tighter lending standards,” “cautious investing” by venture capitalists, and a decline in economic activity moving forward. And Wedbush’s tech analyst Dan Ives said that while the near-term systemic impact of regional banks’ problems is “likely minimal” now that the Fed has guaranteed deposits at SVB, he fears the tech landscape will be forever changed.
Thousands of startups and more than 1,000 private equity funds and venture capital funds, including the likes of Andreessen Horowitz, held capital at Silicon Valley Bank in 2022, according to a Fortune analysis.
“We have heard from many nervous VCs and tech startups over the weekend that they are worried about their employees, payroll, and the uncertain financing world they face going forward post SVB,” Ives wrote in a Monday research note. “The impact from this past week will have major ripple impacts across the tech landscape and Silicon Valley for years to come in our opinion.”
Ives added that a “tighter overall funding environment” will force many start-ups to cut costs and make banks take a second look at lines of credit extended to “unproven tech start-ups with high cash burn.”
On top of the pain that’s already being felt in the stock market and in Silicon Valley, some fear the failure of SBV and Signature Bank could spark a recession. Jay Hatfield, CEO at Infrastructure Capital Advisors, told Fortune that he believes the Fed’s rapid interest rate hikes over the past 12 months meant to curb inflation have created a “financial panic.” Officials should reverse course and implement an “emergency rate cut” to prevent a recession and improve banks’ balance sheets.
“With the looming financial crisis, the risk of a recession is much higher than the risk of moderate inflation,” he warned, noting “the last financial crisis led to a loss of confidence in the economy, mass layoffs and a deep and long recession.”
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