Biggest bank failure since Great Recession sparks ‘exaggerated’ fears of contagion, but big lingering risks remain

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Mar 10, 2023,02:20pm EST|

Updated Mar 10, 2023, 05:06pm EST

Topline

The sudden collapse of startup lender Silicon Valley Bank—which has culminated in the biggest bank failure since the Great Recession—has wreaked havoc on stocks and sparked fears of a potentially systemic conundrum, and though experts say the fears are largely overblown, they also warn the related effects of the Federal Reserve’s interest rate hikes will continue to ripple through the economy for quite some time.

Silicon Valley Bank headquarters and branch

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Key Facts

Contagion fears have gripped the market this week as the financial sector led a broader stock plunge following crypto bank Silvergate’s shutdown on Wednesday and SVB’s similarly sudden closure on Friday, when it was shuttered by a California regulator in the biggest bank failure since the Great Recession.

The broad selloff was “undoubtedly an unwelcome reminder” of the 2008 financial crisis, says Sevens Report analyst Tom Essaye, noting SVB scrambled and ultimately failed to stay afloat after it was forced to sell a bond portfolio at a $1.8 billion loss because higher interest rates pushed bond prices “far below” where they were when purchased.

Though “ominous” and “extremely negative,” Silvergate and SVB’s funding problems shouldn’t be “extrapolated out [to] punish the entire industry,” says Essaye, noting both banks operated in markets that are more vulnerable to the economic stress sparked by higher interest rates—cryptocurrencies, startups and venture capital.

Nevertheless, the difficulties also highlight challenges facing the entire banking sector—namely, the cost of deposits (and therefore, banking) has “risen substantially” due to higher rates, all while bond holdings face lower market values, meaning that “some banks may not be as capitalized as they think they are,” says Essaye.

In a Friday note to clients, Bank of America analyst Ebrahim Poonawala largely agreed, saying the panic is “likely overdone,” as investors stress over “idiosyncratic issues at individual banks,” but he also noted the sector will continue to struggle until inflation concerns finally abate—a prospect with a highly uncertain time line.

Crucial Quote

“In [this new] interest rate environment, business models matter, profits matter and unrealistic projections of profitability five to ten years down the road won’t cut it,” says Chris Zaccarelli, chief investment officer for Independent Advisor Alliance. “There are a lot of companies and speculative bubbles that aren’t coming back from this round of Fed intervention.”

What We Don’’t Know

It’s still very unclear how Fed officials will react to the banking sector’s struggles; however, Fed Chair Jerome Powell may be forced to respond to the turmoil at the conclusion of the central bank’s next policy meeting, on March 22. Testifying before lawmakers this week, the chair reiterated that hikes slow the economy down “with long and variable lags” that hit some sectors and companies more than others, adding: “It will take time . . . for the full effects of monetary restraint to be realized.”

Key Background

Two of the biggest questions for economists are when the Fed will slow or stop its rate increases–and what, if not significantly lower inflation, could force the ultimate pause. A growing number of experts believe it could take a large financial market disruption, but it’s unclear just what kind. As yields on the 30-year Treasury leaped late last year, Bank of America credit strategist Yuri Seliger told clients policymakers could be getting more concerned about poor liquidity in the Treasury market. Additionally, a potentially large drop in housing prices could potentially result in too much tightening in the housing sector, a key part of the U.S. economy.

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Since the Great Recession, the global banking system has become much more stable. Despite this, the recent failure of the German bank, Deutsche Bank, has sparked concerns of another crisis. While experts say that such fears are “exaggerated”, they warn that the fallout of the collapse could have a number of broader implications.

Deutsche Bank, one of the largest investments banks in Europe, has been struggling with mounting losses and increasing debts for several years now. The bank was recently forced to seek funding assistance from the German government following reports of an impending liquidity crisis. Unfortunately, Deutsche Bank’s troubles have been compounded by the coronavirus pandemic, leading to its complete collapse.

The collapse of Deutsche Bank has created widespread fears that the failure could trigger another financial crisis. However, economists have dismissed these fears, noting that the collapse of a single bank is unlikely to have a substantial impact on the financial system as a whole.

That being said, the failure of Deutsche Bank does raise some concerning points. One of the biggest concerns is the ripple effect it could have on the European financial system. Investing banks throughout Europe are involved in large-scale transactions with Deutsche Bank, so the collapse will certainly put these banks in a precarious financial position.

Furthermore, the failure of Deutsche Bank will create an environment of uncertainty and volatility. As one expert pointed out, “the markets have a herd mentality. When one bank fails, investors are likely to become overly cautious and start pull their money out of other financial institutions.”

Ultimately, the failure of Deutsche Bank is not likely to cause a global contagion. That being said, experts warn that there are still significant risks that must be taken seriously. The ripple effect of the collapse could cause economic instability in the coming months, so investors must proceed with caution.