The Washington PostDemocracy Dies in Darkness

Opinion From bank runs to a credit crunch, the financial future looks bleak

A pedestrian walks past a Silicon Valley Bank branch in San Francisco on Tuesday. (Jeff Chiu/AP)
5 min

For a glimpse at why the recent banking mayhem might be far from over, consider two numbers.

Total capital buffer in the U.S. banking system: $2.2 trillion.

Total unrealized losses in the system, as calculated in a pair of recent academic papers: between $1.7 trillion and $2 trillion.

In other words, if banks were suddenly forced to liquidate their bond and loan portfolios, the losses would erase between 77 percent and 91 percent of their combined capital cushion. It follows that large numbers of banks are terrifyingly fragile.

This is, shockingly, a surprise. Until the failure of Silicon Valley Bank on March 10, nearly everyone supposed that U.S. banks were comfortably capitalized. Investors knew full well that the Fed’s interest rate hikes, a necessary but belated response to inflation, had clobbered the bond market. They also knew that banks own a lot of bonds. But the potential scale of the banks’ unrealized losses — the difference between what they originally paid for their bonds and what they now could sell them for — generally escaped remark.

Since March 10, unrealized losses have gotten plenty of attention. But the most widely cited number for the size of the problem has been the one provided by the Federal Deposit Insurance Corporation: $620 billion. Unfortunately, this refers only to the banks’ bond portfolios. By adding in unrealized losses on fixed-interest loans that were made when interest rates were lower, the academics arrive at estimates three times larger.

Of course, unrealized losses matter only if banks are forced to realize them. The scenario in which all banks sell all assets would happen only in the context of a generalized run on the entire banking system, and that is not going to happen. For one thing, deposits worth up to $250,000 are federally insured, so there is little cause for customers to bolt with them. For another, cash that is yanked out of one bank may be stashed in another — although billions will move outside the banking system, to money market funds.

But the point of the academic thought experiment is that the banks are way more fragile than they looked just a few weeks ago — and therefore that even a partial run could be disastrous. One of the papers, by Erica Jiang of the University of Southern California and co-authors, presents a scenario in which customers withdraw just half their uninsured deposits. It finds that 186 banks would be forced to realize losses that would render them bankrupt.

The bottom line is that the fate of the banks will depend over the next weeks on the scarily unpredictable wild card of depositor psychology. The question is whether bank customers, particularly small companies with accounts at vulnerable regional lenders, will take fright and run.

On the positive side, the new Fed backstop announced after Silicon Valley Bank’s failure ought to reassure depositors. It allows banks to avoid crystallizing losses by temporarily swapping their impaired bonds for cash. On the negative side, the backstop is only partial. The Fed’s willingness to accept bonds does not extend to loans, which account for more than half of banks’ problems.

What’s more, this is the first financial crunch to occur in the age of social media. Who knows what rumors — founded or unfounded — could mess with people’s heads? The run on Silicon Valley Bank was lightning fast because news spread digitally and deposits could be shifted with a few swipes on a smartphone. At the time of the 2008 financial meltdown, the iPhone was one year old.

If more bank runs ensue, the authorities will strive bravely to contain the fallout. They have already protected depositors in Silicon Valley Bank and a second failed institution, New York-based Signature Bank. They have encouraged a private rescue of a third flailing lender, First Republic Bank. But if more midsize banks start tumbling like bowling pins, the costs could be substantial. Three decades ago, cleaning up the mess left by the mass collapse of savings and loan institutions is estimated to have cost U.S. taxpayers more than $100 billion.

Even if further runs can be avoided, the size of the banks’ unrealized losses will cause damage of a different sort. Conscious that their capital cushions are threadbare, banks will pull back from lending: There will be a credit crunch. Fewer loans for consumers might actually be a good thing, since demand has to cool to bring down inflation. But less capital for businesses will hit the economy’s supply side. It will mean lower production, more bottlenecks and higher inflation.

At the height of the 2008 crisis, policymakers fixed the problem of capital-short banks by forcing them to accept capital injections from the government. But this semi-nationalization was hated by bank shareholders, whose ownership was diluted; and today’s market conditions are not (yet) extreme enough to warrant such radical action. The upshot is that the economy might be hobbled by zombie lenders for the next year or more. Such is the price of an inflationary bubble that the Fed was too slow to pop.