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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Anatomy of a bank failure

Three of the four largest bank failures in US history occurred in the past month. Yet while there have been some deposit flows into larger institutions and stress continues, there is little evidence of an impending systemic crisis a la 2008. This is due largely to the rapid and efficient action of the FDIC in managing the orderly transition of deposits to healthy banks at no direct cost to taxpayers.

The collapse of Signature Bank, Silicon Valley Bank, and First Republic required the FDIC to reach deep into its bag of tricks and provided a fascinating display of its inventory of tools for stabilizing the financial system.

During the Great Depression, 9,000 American banks collapsed and $7 billion in deposits evaporated. Lacking adequate tools to systematically address the crisis, President Franklin Roosevelt announced a 4 day “bank holiday” in 1933 that broke the fever, and that same year signed the Banking Act that established deposit insurance and created the Federal Deposit Insurance Corporation.

Broad deregulation in the 1980s that allowed commercial banks to take on more risk combined with a string of bank failures prompted a bigger role for the FDIC in winding down insolvent financial institutions, culminating in the 1991 FDIC Improvement Act that mandated the swift liquidation of failed banks and provided authority to move decisively. That authority was tested, and procedures were honed, over the next 2 decades as 561 banks failed from 2001 to 2020. There were no failures between 2021 and the collapse of SVB in March.

Unlike other business types that can be liquidated by the bankruptcy process, banks are too integral to the economy to be allowed to collapse and take families and businesses down with them. Instead, failed institutions are dissolved by a process called “resolution” aimed at protecting depositors to the greatest degree possible.

Banks fail for several reasons, but most commonly due to lack of liquidity or insufficient capital that violate regulatory thresholds or render the bank unable to meet withdrawal requests. In the event, the bank’s principal regulator appoints the FDIC as receiver responsible for overseeing the orderly dissolution of the institution. There are 2 main resolution paths depending on the size and circumstances of the failure.

The preferred response is finding another healthy bank to step in and acquire the failed institution, called a purchase and assumption transaction (P & A). The FDIC solicits bids from qualified institutions for the deposits and assets of the failed bank and chooses the offer projected to be the least costly to the Deposit Insurance Fund (DIP), the insurance pool funded by assessments on all banks. Once a deal is struck, the FDIC shuts the old bank on Friday and the acquirer reopens the following Monday conducting business as usual.

First Republic Bank, now the second largest collapse in US history, was resolved by a P & A agreement with JP Morgan. JPM assumed all the deposits and most of the assets of First Republic including its 84 branches on May 1 as FRB customers became JPM customers. As is usual, the FDIC agreed to share a portion of any loan losses and provided some financing for the transaction from the Deposit Insurance Fund. FRB shareholders and most creditors are wiped out. According to Barron’s, about half a dozen banks including PNC submitted bids.

If no bidders for the failed bank come forward, the FDIC proceeds with a deposit payoff. Depositors receive a check from the DIP fund for the full amount of their insured deposits up to the statutory limit (currently $250,000 per account type). Accounts that exceed the insurance limit receive claims against the bank. As the FDIC sells off the assets, these uninsured depositors may receive a partial recovery during the final liquidation.

What makes the recent collapses notable is the panoply of tools deployed by the FDIC. The first two failures, Signature and Silicon Valley, erupted so suddenly and acutely that the purchase and assumption process was deemed too slow. Recognizing the risk of additional bank runs, the FDIC invoked its special authority to waive the lowest cost requirement under what is called the “systemic risk exception”. Exigent circumstances allow the agency to step in and run the bank until an acquirer can be found.

Recognizing the systemic risk posed by a failure of Silicon Valley Bank and in particular its substantial liabilities for unsecured deposits, the FDIC as receiver shut down SVB on March 10 and transferred all the bank’s assets and deposits to a new entity called “Silicon Valley Bridge Bank” on March 13. The temporary entity owned by the FDIC continued to operate normally and honor withdrawal requests and guarantee the unsecured deposits until an acquirer could be found. By March 27, Raleigh-based First Citizens Bank acquired the deposits and assets of the Bridge Bank under comparable terms to those of the JPM transaction. A similar tack was taken when New York Community Bank agreed to assume Signature Bank.

There is never a shortage of criticism when regulators are faced with a failed bank and there certainly may be a few more smaller failures, but the rapidity of the response and the deployment of the FDIC’s full arsenal in dealing with some of the biggest bank collapses in history appears to have succeeded in averting a much bigger crisis.

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