First Republic has failed. Now what?
Banks tend to fail a little bit like restaurants. The lights are on and all is well one day; then someone has arrived with a clipboard to auction off assets the next. That’s more or less what happened in the case of First Republic Bank.
Late last week, regional bank First Republic announced that it could no longer cover its deposits and obligations. This set off a 48-hour scramble on the part of the FDIC to secure the institution. On Monday, the agency announced that it had brokered a deal to sell First Republic to JP Morgan, which has a history of buying up failing banks at the government’s request. Federal depositor insurance will cover some account balances, and JP Morgan will take over First Republic’s deposits, loans and other business.
It’s the second largest bank failure since Washington Mutual collapsed in 2008. More troubling still, along with Signature Bank and Silicon Valley Bank, it is the third out of the four largest bank collapses in U.S. history, all of which have taken place in the last few months.
Yet bank failures happen at, as economists like to say, a very 30,000-foot level. They are abstract, especially given that the FDIC has done its job and preserved the value of deposits. The question is, what does this mean for individuals and households? Are these matters that should worry you?
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The answer is… a little. Nobody knows exactly what will happen yet and, in large part because of that uncertainty, many of the potential outcomes are both speculative and even mutually contradictory. But a few ways this might affect your life include:
More Risk Of A Recession
For months now the watchword of 2023 has been “recession.” Economists keep predicting one will happen, and the Federal Reserve seems intent on turning those predictions into prophecy in order to break a perceived wage-price cycle of inflation. Inflation has significantly declined, and there is strong evidence that 2022’s price increases were more linked to pandemic distortions than consumer wealth, but this has not slowed the fastest series of interest rate hikes in modern history.
Now, add banking uncertainty to that mix. Reporting indicates that many other banks have potentially weak finances, and the entire financial industry looks uncertain in the wake of three significant collapses. That can ripple across the economy in any number of ways. Businesses are less likely to expand during periods of uncertainty; banks are less likely to lend; households are less likely to spend, particularly on big-ticket items. All of this can add up to an overall economic slowdown.
Now, that recession is by no means a guarantee. Many other market indicators look strong, and if regulators and industry members can fix the banking sector relatively quickly then this might be just a troubled springtime. But it’s very fair to say that the uncertain risks of a recession just got higher.
Maybe Lower Interest Rates
At time of writing, the Federal Reserve had not yet announced its May 3 interest rate decision, but all signs pointed to yet another rate hike. This would be the latest of a continuous series aimed at breaking 2022’s high inflation. Yet, combined with significantly lower inflation rates, the recent banking failures might slow that trend.
At time of writing, banks held between $1.6 trillion and $2.2 trillion in troubled assets, and much of the problem comes from how interest rates have changed the value of long-term debt. This has created a market-wide air of uncertainty and, essentially, “who’s next.” Many economists have pointed out that lowering interest rates would help ease these concerns. It would make borrowing cheaper, boosting most banks’ core business model, and it would reduce some of those losses.
While it’s unlikely that First Republic’s failure will change a potentially planned rate hike on May 3, the Federal Reserve may slow, pause or maybe even reverse its interest rate increases going forward as a way of stabilizing the financial markets. It’s only one of several possibilities, but a realistic one.
Or Maybe Tighter Lending
Or it might not. At time of writing, year-over-year inflation was around 5%. Even though inflation has been falling since July, 2022, it is still well above the Federal Reserve’s benchmark 2% rate. And the central bank has made clear that it intends to bring that number back down.
At the same time, many experts are warning of a “credit crunch.” This is when banks reduce lending industry-wide, making it both more difficult and more expensive to get a loan. That slowdown in turn affects virtually every market in the economy. Consumers can’t buy as many products, particularly large products like cars and houses. Businesses are less likely to hire and expand, particularly ones which rely on credit for short-term cash flow issues like payroll. Industries as a whole see a decline in revenue and operations. The list goes on.
Banks restrict lending during periods of uncertainty, preferring to keep their cash on hand. That’s even more true in an era of high interest rates, when they can more easily put that money into something safe like Treasury debt. At the same time, high interest rates increase the baseline cost of lending, slowing credit even further. The overall result might be an era of tight lending that, as noted above, could significantly contribute to a potential recession.
Potentially More Bank Consolidation
JP Morgan has developed a reputation for taking over troubled institutions, as it did with First Republic. If more banks fail in the coming months, expect that trend to continue.
There are two issues going on with the current run of bank failures. The first is simple size. Larger banks tend to be more insulated from failure by their sheer cash reserves. They have more resources with which to weather bad investments. (As the world saw in 2008, that is not an ironclad protection, but it helps.) Smaller and mid-sized banks do not, so they are more likely to fail when the market turns.
The second is deregulation. In 2018 the Trump administration rolled back some oversight laws for mid-sized, regional banks arguing that the rules were unnecessary. Among other issues, the administration cut stress test requirements, an oversight process that attempts to determine a bank’s level of risk and its exposure to changing market conditions.
Just a little more than four years later, Silicon Valley Bank, Signature Bank and First Republic Bank all failed because they had high-risk portfolios that collapsed under changing market conditions. There is significant evidence that more regional and mid-sized banks may have similar structural problems, but no way to know for sure because of this reduced oversight. As a result, it’s possible that more banks will fail in the coming months and years. If that happens, the FDIC will sell them to institutions large enough to absorb those risks and assets, continuing the growth of large banks at the expense of smaller ones.
Higher Banking Fees
Finally, it’s possible that all of this could lead to higher fees for ordinary services and transactions. There are two reasons for this.
First, particularly smaller banks may respond to the current uncertainty by taking a less risky approach to their portfolios overall. This will involve moving away from higher-return, higher-risk investments and toward lower-return, safer investments. In that case they’re likely to try and make up that lost revenue elsewhere, including in the form of higher banking fees.
At the same time, when the FDIC insures deposits it does so through a fund that banks contribute to, including through quarterly fees that the FDIC charges to all member institutions. When First Republic failed, the FDIC had to dip into this insurance fund. If it has to continue doing so, then the FDIC may increase the quarterly fees that it charges member institutions to offset those payments. In that case banks are likely to pass those increased costs on to consumers in the form of higher transaction fees.
Three of the four largest bank failures in history have taken place within the last two months. There’s no clear answer as to how this will affect individual consumers, with the possibilities ranging from nothing at all to easier borrowing to an outright recession.
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