Chronicles of the banking crisis - part 2.
First Republic collapse, common patterns, and some thoughts.
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This is part 2 of the Chronicles of the Banking Crisis and more.
If you missed out on part 1 - here is the full article, covering the first few banks to collapse (aka Silvergate Bank, Silicon Valley Bank, and Signature Bank), the impact in USDC stablecoin depegging, and the US regulators chokepoint strategy.
It certainly sounds like a lot to cover in one article. But guess what, that’s not the complete saga yet.
Today, we are bringing you the continuation of the story, with yet another bank collapsing, and we will explain a bit more what are the key concepts you need to understand to grasp why these banks are failing.
So let’s start with some facts.
The collapse of First Republic Bank
How it Happened?
First Republic was a regional bank based in San Francisco, California. It caterred to high net worth clients.
Customers started withdrawing cash at the time of SVB collapse. However, First Republic Bank got additional funding from the Fed and JP Morgan, and had a whoopy $70B of liquidity injection.
However, this wasn’t enough. As a publicly traded company, the bank had to publish its earning report, and when it came to the time to publish Q1’s report, it stated that its total depost has fallen by 41% to $104B.
This was a shock for investors. We all know at this point that investors don’t like surprises, and with this news, it caused the bank’s stock price to fall even more, which of course triggered even more customer withdrawals, and there we have it - a bank run.
Long story short - First Republic was sezied by the US regulators, subsequently sold to JP Morgan.
Some Perspective…
Below is a screenshot I took from a podcast episode by Bankless, which I think is very helpful to help us visualize the magnitude of the events happening around us.
Let me explain: each circle represents a fallen bank.
You can clearly see that the 2008 financial crisis left behind an immense amount of banks, but with the expection of a handful, these banks were mostly very small.
Now, if you look at the right corner in 2023, we only see few circles, but their size is really concerning - we are pretty much talking about the collapse of the 2nd and 3rd largest US banks to fail in the US history.
Why do banks fail?
By now you might be wondering why do these banks fail? and why these ones in particular, are there any common patterns?
Great questions. This is a complex subject, and I don’t think I can give a comprehensive enough answer, but what I can do though is share some of the common factors that play a critical role here that you should know about.
1. Fractional Reserve.
Banks operate based on the Fractional Reserve Banking system.
This means that banks are only obligated to keep a small percentage of your money on hand to have the cash in case you need to withdraw it, while they invest up to 90% of the rest of deposits. And yes, this is legal.
Therefore, your money in your bank account technically is not there, its primarily being lent out or invested so that it can make money.
Now, this works so long everyone doesn’t rush to withdraw their money at the same time. And normally, this is the norm because why would all of us withdraw all our deposits at the same time?
It is only when we lose trust in the bank. If people don’t trust, then they will all rush to withdraw their money, and there you have it, another bank run.
2. Unrealized Losses.
When you hold an asset, and its price decreases, it is an “unrealized loss” on paper, but as long as you don’t sell it, you are not really losing this value. If you prefer, and can wait and hold the asset until it eventually recovers in price, you can revert from this potential loss and instead make a profit out of it.
So when we extrapolate this back to the banks’ situation, we already said that they can invest up to 90% of the customers’ deposits, which means they have high amount of investments, and more often than not, these are hold to maturity and highly iliquid, like treasury bonds, mortgage, etc.
When everyone rushes to withdraw means that banks have to sell their assets to honor those withdrawals. This will turn unrealized losses into actual realized losses, causing the bank to lose a lot.
3. Uninsured Deposits
The FDIC (Federal Deposit Insurance Corporation) is a US government corporation that provides deposit insurance coverage.
However, they only insure bank accounts with less than $250,000. Those commercial deposits and high net worth individuals’ deposit will likely exceed this amount, and when any emergency happens, will not have insurance coverage.
If we look at the percentage number of uninsured deposits over its total deposit, we can see the Silicon Valley Bank, Siganture, and First Republic were ranking as the top 3 banks. Not a coincidence.
…………………
Some Thoughts
So these are some of the common factors we can observe from the fallen ones this year.
Now, its time to call out that First Republic Bank had around 80% of its asset in the form of mortgage.
It has nothing to do with crypto.
If it has nothing to do with crypto, why are we talking about it in this forum?
Well, if crypto offers an alternative to traditional financial institutions and players, this seems like the right occassion to remind ourselves that having an alternative to banks is not such a bad idea.
Again, I’m not saying we should 100% replace the banks. However, spending some time in understanding the systemic risks and why certain banks are going down, as well as exploring an option that you might want to consider when it comes to derisking, can be a very empowering thing, and can save the day.
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