A Market Test to Avoid Another Government Bank Bailout

Silicon Valley Bank’s failure began several of the largest bank failures in American history, leading the federal government to step in to prevent widespread contagion. Thousands of banks are still in trouble, but there is a more cost effective way to solve the banking crisis that doesn’t require trillions of dollars from the government.

Silicon Valley Bank and others failed because they invested large numbers of assets in long-term, low-interest bonds and loans, and did not protect themselves from the risk of higher interest rates. They were also financed in large part by uninsured, “flighty” depositors. As a result, when interest rates rose over the last year as the Fed tightened monetary policy, the value of their assets fell, and their flighty customers ran to withdraw their funds.

Research that my colleagues and I did during the weekend of SVB’s failure suggests that when the assets that all US banks hold are measured on a mark-to-market basis based on interest rates today—that is, not based on their value at maturity but at current prices if assets were sold today—balance sheets of American banks are $2 trillion lower than their current book values. This is a large number if you compare it with the $2 trillion aggregate equity in the US banking system as of March 2023.

A full accounting of these losses has been avoided by banks’ ability to maintain held-to-maturity assets at their book value. That is, these losses are unrealized for now. But there is no avoiding the economic reality that the true value of equity capital in the banking industry has fallen by at least this amount.

This is a problem.

These reductions in asset value are unequally distributed across the system, with some banks being particularly hard hit. In a well capitalized banking system, the distribution of the equity to asset ratio you would want to see across the 4,800 banks in the U.S. banking system would be above zero. But our analysis suggests that the entire distribution shifts to the left when accounting for mark-to-market valuations. 

Over 2,000 banks – accounting for $11 trillion of assets in aggregate – fall below the 0% line.

The important implication of this analysis is that the recent fragility and collapse of several high profile banks is not an isolated phenomenon. Nearly half of U.S. banks could face similar difficulties if forced to liquidate a significant fraction of their assets in the wake of large deposit withdrawals.

How can the government avoid the calamitous path taken all too often of regulatory forbearance, as in the US Savings and Loan crisis, the Japanese banking crisis, and the European debt crisis? 

Economic solvency requires a market test. The ability to raise new equity or long-term unsecured debt from outside investors is one such test that draws a clean line between “solvent but illiquid,” and “insolvent.” Solvent banks with franchise value would be able to attract such capital. In addition, new capital inflows would reduce fragility and restore “skin in the game” for these institutions. 

There are two options for making sure more solvent but illiquid banks don’t fail. The traditional regulatory lever is to raise capital requirements, i.e. require banks to have more cash on hand available for depositors to withdraw. But that is not a good prescription for solvent banks that are currently stressed. It would result in solvent banks contracting their lending.

The course of action we recommend is instead for the government to require raising capital via equity. The amount per bank would be assessed by regulators on a bank-by-bank basis.

In other words, banks would shore up their balance sheets by selling issuing public shares or some other form of equity to increase their cash on hand.

To avoid the stigma of an equity raise, it would have to be required across all banks.

In the immediate term, regulators could also help banks increase their equity buffer by restricting equity payouts and tie continued access to government lending facilities to increased equity.

Something must be done. Banks are too fragile in today’s interest rate environment. And there is likely to be turbulence in the commercial real estate market soon as businesses deal with the permanent work-from-home phenomena. 

Regulators have a tough job ahead of them. Providing insolvent banks a lifeline will sow the seeds of a crisis in the future that would have banks “gambling for resurrection” similar to the Savings and Loan Crisis of early 1980s. Our proposal asks regulators to rely on the market to determine which banks are truly insolvent. Requiring banks to raise equity capital now will be less disruptive to the economy than having a large number of small and medium sized insolvent banks drain taxpayer resources and eventually, fail.