Why Banks Keep Failing

Three previously solid, medium-size banks suddenly faced annihilation. The blame lies with the system itself.

Signage at a First Republic Bank branch in New York.
Stephanie Keith / Bloomberg / Getty

In March, Silicon Valley Bank, once the envy of the nation’s tech elite with more than $200 billion in assets, went down the tubes in a flash—pretty much 36 hours from start (rumors of its insolvency) to finish (the announcement of a takeover by the Federal Deposit Insurance Corporation). It was the second-largest bank failure in American history. Only the failure of Washington Mutual, which had more than $300 billion in assets when it went under in September 2008, was larger. Two days after the SVB disaster, the little-known Signature Bank, which had about $100 billion in assets, also failed. That was the third-largest bank failure in American history.

This weekend, First Republic Bank, with $233 billion in assets, is anticipated to meet its demise. In February, the bank’s stock was trading for $147 a share; it’s now about $3.50, a decline of 98 percent. When First Republic fails and is seized by the FDIC, as is widely expected to happen, it will replace SVB as the second-largest bank failure in American history.

What’s going on? Why did these three previously solid, medium-size banks suddenly face annihilation? The answer lies in the nature of banking itself. Our so-called fractional banking system is fundamentally risky and vulnerable to external shocks, like the recent rise in interest rates, which these banks’ managers should have anticipated—but evidently had not.

When we deposit the after-tax proceeds of our salaries into a bank, we like to think we have put the money in a safe place and that it will always be there for us when we go to the ATM machine and want some of it back. In theory, we’re safe to assume this will be so. Some of our cash is at the bank all the time, and, of course, we can always withdraw $100 here or $200 there. But the majority of the money we deposit in banks is not kept in the banks’ vaults.

That’s the essence of “fractional banking.” The way a bank makes money—and American banks primarily are private, profit-seeking enterprises—is by taking our deposits and then lending that money out to individuals, companies, universities, and municipalities. To anyone, in fact, who can meet required credit standards and has the wherewithal to pay for the borrowing in the form of fees, interest, and principal payments. The difference between what a bank pays us for our deposits and what it receives in interest payments and assorted fees from borrowers of all sorts is, essentially, one of the important ways the bank makes a profit.

For instance, my own bank, JPMorgan Chase, pays me one basis point of interest on my checking account each year (0.01 percent), and two basis points (0.02 percent) on my savings account—practically zero. JPMorgan Chase has something like $2.5 trillion in total deposits. This is one of the resources the bank uses to make loans to generate revenue. In other words, JPMorgan Chase gets its raw material for very close to free. (It’s hard to find an industry besides depository banking for which that is true.)

JPMorgan Chase then takes this raw material—our deposits—and lends that money out for five, seven, or 10 years or more, at much, much higher interest rates, plus all of those fees. The difference between the nearly zero that it pays for our deposits and what it gets back from borrowers forms the majority of the bank’s profits. JPMorgan Chase made $48 billion in net income in 2021, and about $38 billion last year.

Bank profits have positively gushed in recent memory thanks in large part to the Federal Reserve’s 13-year (2009–22) so-called Zero Interest Rate Policy, or ZIRP. Under ZIRP, the brainchild of the former Fed Chair Ben Bernanke—and a policy pursued by his successors Janet Yellen (now the treasury secretary) and Jay Powell—the Fed went into the market and bought all kinds of debt securities in bulk. During that period, the Fed’s balance sheet increased roughly 10 times to nearly $9 trillion in assets, up from less than $900 billion in assets before the 2008 financial crisis. What Bernanke and his successors decided, in their wisdom, was that, after that crash, the U.S. economy, which had plunged into the Great Recession, needed a jump start in the form of low interest rates. The Fed figured that if the cost of money were cheap enough, people would borrow more and use the lending to invest in hiring more employees, building new plants, acquiring new equipment, expanding overseas, and so on.

This seemed like a brilliant idea, and for a time it was: It largely succeeded in stimulating a moribund economy, despite the congressional deadlock that was holding up any fiscal stimulus. The Fed’s aggressive monetary policy in effect replaced what normally might have been an appropriate fiscal response from Congress.

Low rates were a boon to the sectors of the economy that make money from money—banks, hedge funds, private equity firms, alternative asset managers—and benefited those that borrow money, such as the federal government, municipalities, homeowners, and corporations. For people on a fixed income,  such as retirees and pensioners, however, ZIRP was terrible because their savings generated so little income. That was the trade-off that the Fed decided to make, and the rest of us went along, not that there was much any of us could do about it.

As beautifully as ZIRP worked for some, it went on far too long. In the end, the Fed’s policies pushed down interest rates to the lowest levels in recorded history. Finally, after more than a decade of short-term interest rates close to zero and long-term interest rates at historically low levels, Powell started reversing course in 2022.

And now the unintended consequences of the Fed’s monetary policy have emerged in the form of the failures of SVB, Signature Bank, and First Republic Bank. First Republic—like SVB and Signature—had a portfolio of loans issued at the top of the market. Specifically, First Republic issued jumbo home mortgages to its wealthy clientele at cheap rates. This strategy was good for the borrowers, who loved the bank, but it was bad for the bank’s risk profile, especially after the Federal Reserve started aggressively raising rates. If you own a portfolio of bonds or mortgages issued at low rates, the portfolio loses value rapidly on a mark-to-market basis when interest rates rise.

In its first-quarter financial statements, First Republic announced that depositors had withdrawn some $100 billion in a matter of days after the collapse of SVB, which was itself precipitated by withdrawals of more than $40 billion the day before its failure. That double whammy—depositors fleeing, asset portfolio underwater—has led to First Republic’s demise.

To be clear, these three banks’ managers should have anticipated that ZIRP wouldn’t last forever, and should have planned accordingly. But they didn’t. In addition to their own bad risk management, the banks successfully lobbied for less regulatory scrutiny from the Feds because they weren’t among the nation’s biggest banks. President Donald Trump signed that deregulation into law in 2018. On Friday, the report on SVB’s failure from the Fed’s vice chair, Michael Barr, found that this relaxation of regulation had “impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach.”

Recent bank failures should be a salutary reminder of the risks inherent in a fractional banking system—how fragile banks really are, and how susceptible to a devastating loss of confidence. The fractional banking system works only if people have confidence in it and in their money being there when they want it. But no bank can withstand a panic for the very reason that, for the bank to make money, the majority of our money isn’t in the bank. Banks’ business plans are built on this mismatch between assets and liabilities. When things go wrong, very little can be done to save the institution. Reportedly, JPMorgan Chase, Bank of America, and PNC are vying to buy the carcass of First Republic once the FDIC takes it over.

Fortunately, although all three of these failed banks were of some regional importance, they were  peripheral to the operation of our capital markets. Their failure should not lead to anything like what happened in 2008, when several huge Wall Street banks went down. That was as close as we have come since the Great Depression to a meltdown of the entire financial system. To that extent, the 2010 reregulation of big banks in the Dodd-Frank law has helped keep our banking system intact. The center is holding, at least for now.