The dominoes continue to fall in the banking industry. Earlier this month, federal regulators announced that they had closed First Republic Bank after the bank failed to meet its liquidity requirements. The closure of First Republic Bank marks the third major bank to fail this year and the second-largest failure in U.S. history.
Despite efforts made by the Federal Reserve and Congress to help struggling banks avoid failure, rising interest rates and tight credit markets have continued to plague the industry. The banking contagion, which started in March following the collapse of Silicon Valley Bank and Signature Bank, has now spread to the fourteenth largest banking institution in the United States. The failure of First Republic Bank has sparked concerns about the precarious state of the U.S. financial system, with some analysts predicting that more banks will be forced to close as fears of an economic slowdown continue to mount.
Spiraling Risk of Financial Contagion
The bankruptcy of First Republic Bank is a grim reminder that the contagion risk posed by one bank’s failure can quickly spread to other banks, infecting the entire system. Even after the $30 billion lifeline provided by some of America’s largest banks, First Republic Bank was unable to survive the onslaught of losses and record deposit outflows during the first quarter of the year.
So why, after all the efforts made to help First Republic Bank, did it fail? The answer is simple: When a major bank like Silicon Valley Bank or First Republic Bank fails, it shakes the bedrock of the financial system, setting off a chain reaction of mistrust and fear that can quickly spiral out of control. Institutions with weak fundamentals and excessive exposure to liquid assets, as well as banks with high levels of leverage and low margins of safety, are often the first to go — as was the case with Bear Stearns in 2008 and now First Republic Bank.
Despite policymakers efforts to contain the contagion by backstopping depositors and providing capital to struggling banks, panic has already started to spread beyond Main Street to Wall Street as investors brace for more closures. The ripple effect of First Republic Bank’s failure has begun, and according to analysts, it could reverberate throughout the U.S. financial system.
PacWest Bancorp, another California-based lender, saw its stock price tumble more than 50% in light of First Republic Bank’s closure in early-May. The regional bank has lost over 80% of its stock price since January, with analysts citing its high concentration of risk at the sector level for its vulnerability to the ongoing financial contagion.
Western Alliance Bancorporation, another regional lender, saw its stock price drop 15% following the news of First Republic Bank’s failure amid renewed concerns about the stability of the U.S. banking industry. The Arizona-based bank has lost more than 65% of its value since the start of the year as investors have become increasingly concerned about its exposure to escalating losses in sectors like hospitality and auto lending.
Amid the recent spate of bank failures, the US Treasury Department has attempted to ease market anxiety and prevent a systemic collapse by providing targeted relief to eligible banks through its Exchange Stabilization Fund. With the risk of contagion spreading, press releases were issued to try to restore confidence in the U.S. banking system. “The banking system remains sound and resilient, and Americans should feel confident in the safety of their deposits and the ability of the banking system to fulfill its essential function of providing credit to businesses and families,” said one Treasury Department official following the news of First Republic Bank’s closure.
But the problems facing First Republic Bank may be symptomatic of deeper issues in the banking industry that require swift and decisive action — not the ad-hoc measures taken by the Federal Reserve and Congress in recent months. And according to Pershing Square’s Bill Ackman, “hours matter” when it comes to restoring confidence in the banking sector but “we have allowed days to go by.”
“Confidence in a financial institution is built over decades and destroyed in days. As each domino falls, the next weakest bank begins to wobble,” Ackman added. Under the current circumstances, regional banks may not be able to withstand news — merited or not — that could be interpreted as a sign of systemic distress.
Despite the Treasury’s assurances, 90% of Americans do not have high confidence in banks and other financial institutions. With three of the four largest bank closures in the U.S. occurring in the last three months, the banking sector may be teetering on the brink of a crisis that could have far-reaching implications for businesses and consumers alike.
A Bumpy Road Ahead
Pessimism is mounting that could lead to further bank closures in the months ahead. If depositors remain spooked by the closure of First Republic Bank and Washington is stuck in the the tradeoff between fighting inflation and economic stability, then the road ahead could be a bumpy one for regional banks and their customers.
Under this scenario, tightening credit conditions and weakening confidence in the banking system could lead to a credit crunch that would make it difficult for banks to maintain adequate liquidity and extend capital, according to analysts at Moody’s. Higher borrowing costs would cause consumer spending and business investment to decline, undermining economic growth and deepening the country’s current economic woes. A growing number of loan defaults and a surge in bad debt could further weaken the banking sector as banks scramble to meet capital requirements. And with vulnerable regional banks holding about 80% of outstanding loans in the U.S. commercial real estate market, analysts fear that a wave of mortgage defaults could severely impair the banking industry’s ability to sustain itself.
A Bright Spot Amid the Gloom
With confidence in the banking system crumbling, precious metals could see an upside. According to John Reade, Chief Market Strategist at the World Gold Council, “A crisis-driven major move into gold usually occurs only when investors and savers start to look for alternatives to the US dollar, fueled by fears of US dollar weakness, inflation or about the very fabric of the financial system.” Investors did just that following the collapse of Lehman Brothers in 2008, pushing gold prices to record highs. With lingering inflationary fears pressed against a backdrop of concerns about spreading financial contagion and economic instability, gold prices have surged again in recent weeks as investors have sought to diversify their wealth in the midst of a banking crisis.
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