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As we have been saying for several of our previous quarterly economic updates, as inflation goes, so goes the U.S. economy.
A quick and rapid descent of inflation will take pressure off the Fed to continue raising rates and the possibility of a soft landing improves. The longer inflation remains elevated, the more aggressively the Fed will have to act, likely triggering a recession.
Overall, the financial sector appears well-positioned for an economic downturn.
That being said, it is important to take stock of some recent high-profile bank closures among regional banks. At the time of writing, Silvergate, Silicon Valley Bank, and Signature Bank all closed within a short period of time causing concerns about the stability of the financial sector overall.
Financial Sector Stability Following Recent Bank Failures
It is not uncommon for a few institutions to experience solvency challenges in an unusually rapidly increasing rate environment. Longer-term loans written at the previous lower rate levels are now being funded by shorter-term deposits and loans at much higher rates. This interest rate mismatch can be a challenge for any experienced financier.
However, as was the case with the three aforementioned failed institutions, excessive concentration can magnify these challenges. Normally, its excessive concentration of lending that can leave an institution overexposed to risk in one sector (like real estate). But, in the case of these three, it was overexposure of deposits coming from the same sector—crypto in the case of Silvergate and Signature and tech startups in the case of Silicon Valley.
Volatility in cryptocurrency led to large deposit outflows for Silvergate and Signature, while high interest rates forced tech companies to use their savings deposits to pay employees rather than raising additional expensive capital in the case of Silicon Valley.
Adding to this drawdown in deposits were unrealized losses on bonds and mortgage-backed securities that have seen valuations drop with rising rates. Silicon Valley in particular saw large write-downs in their capital due to a larger concentration in Treasury Bonds.
Nearly every financial institution in the country has experienced the same mark-to-market write-downs, but not the magnitude as Silicon Valley Bank. The loss of deposits and equity value left these three banks with insufficient capital. Furthermore, it should be noted that none of these institutions became insolvent due to poor lending practices or defaults.
To prevent concerns of a larger spillover to other banks and address these potential mark-to-market write-downs of capital, the Fed, FDIC, and Treasury announced measures to essentially guarantee all deposits (regardless of amount) and provide financial institutions access to up to one-year funding using their treasuries as collateral, at face value and not their current mark-to-market values. The intent was to assure depositors their money is safe in the U.S. financial system and avoid any “runs on the bank” that can create liquidity challenges for even the healthiest of institutions.
At the time of writing, financial markets received this announcement well. However, a number of regional bank stocks saw significant selling and loss of market value. While it seems apparent that these three failures were isolated and institution-specific, it cannot be ruled out that additional institutions may succumb to the rate environment if they have not been prudent in managing interest rate risk on their balance sheets and avoiding overexposure to specific rate-sensitive sectors in both their lending and deposit activities. The Treasury, Fed, and FDIC special liquidity and deposit guarantee actions should prevent any unnecessary failures.
With all of that in mind, we are unlikely to experience the negative feedback loop seen in many recessions of people losing jobs, defaulting on debt, and causing financial institutions to tighten further on credit conditions (causing additional economic slowing) to maintain their capital ratios in accordance with regulatory requirements.
Overall, while we do expect net interest margins and overall profitability to be challenged this year for the financial industry, the sector seems well braced for the pending economic slowdown. There will be further deterioration in the loan portfolio, but it should be more than manageable.
While additional bank failures are possible, they should remain isolated. The overall risk to the financial system, while more elevated from a year ago, remains low. 
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