The US Banking Crisis 2023 Explained In Simple TermsMar 23, 2023
In early March, three US banks were closed down by regulators. These are Silvergate Bank, Signature Bank, and Silicon Valley Bank. It has been causing a lot of fear in the market, and I've been getting lots of questions about it.
In this article, I'll explain why this is happening, and more importantly, what we can do as depositors or investors.
So, what happened?
To understand this, let's begin with the idea of how banks work.
Key Idea #1: How Banks Work
When we deposit money in banks, it's common knowledge that they do not store it all in a vault and keep it there until we withdraw it again. They'll use a portion of that money to loan out or to invest.
Now by law, banks are usually only required to hold a certain percentage (typically 10%) of the deposit in reserve. The rest, they are free to reinvest. This is what's known as the 'fractional reserve' system.
For example, let's say 'Dennis' made a $1,000 deposit with a bank. If the reserve rate is 10%, the bank may then only keep $100 as cash. The $900 left would be used for investments, so that the bank can also make money from the deposit.
So how is this relevant to what's happening with the banks?
Under normal circumstances, this practice of keeping only around a certain percentage of deposits as cash, is actually an accepted practice. This is because banks typically have hundreds and thousands of depositors so that percentage of ALL deposits is already a lot. This amount is usually more than enough for the day to day withdrawals of each individual depositor.
After all, it's not going to be likely that all depositors will withdraw money at the same time. This is what makes the fractional reserve system work.
So where did things start to go wrong?
To answer that, we follow where the 90% went.
Key Idea #2: Where The Banks Invested the 90%
Over the last few years, many banks (and not just the the three banks mentioned above) invested in bonds.
So what are bonds?
Here's a quick oversimplified example on how bonds work as investments.
Let's say the bank bought a 10-year government bond with a yield of 5% using Dennis' money of $900.
Every year the bank would earn 5% of $900, which is $45. And because the bond is for 10 years, this would happen for the next 10 years.
On the 10th year, the bank will get back the $900 plus the interest of $45 for that year.
So pretty good deal so far right?
Everything is going well for the bank at this point because they've basically secured income from Dennis' deposit for the next 10 years. And because they have tons of other depositors, they'll always have enough cash for dealing with the day to day withdrawals.
So what started the problems that lead to this collapse?
Let's talk about how bonds and interest rates affect each other.
Key Idea #3: The Relationship of Bond Prices and Interest Rates
To put it simply, when interest rates go up, the value of bonds go down.
I won't get into the details of how this interaction works, but what is important to know are two things:
- The value of the bonds can change over time.
- Bonds can actually be bought (and sold) to other investors again at the 'marked to market' price.
So in our example the $900 bond that the bank initially bought a few years ago, could be priced at $1,200 or even $500 depending on how 'bond market' is going.
Again I won't go into the details of this (as it deserves an article of its own), but what happened was the value of the bonds over the past few years have been going down, because interest rates have been going up.
So from a purely financial standpoint here's the 'before and after' for the bank.
- Cash: $100 (from Dennis deposit)
- Bond Investment: $900 (from Dennis deposit)
AFTER BOND PRICES WENT DOWN:
- Cash: $100 (from Dennis deposit)
- Bond Investment: $500
Now to clarify this situation, the bank would still actually get $900 after 10-years and will keep on earning $45 per year from the bond.
But from a numbers standpoint, if Dennis (and all other depositors suddenly) wanted to withdraw, the bank would not have enough money to actually pay Dennis! (Again this is because the bond value had just dropped.)
The problem is a duration mismatch. The money of the depositors can be withdrawn anytime. However, the investments chosen by the banks are of a longer term nature.
This is why the government had to step in and take control of their assets.
So why is this becoming a big deal?
We now go to our final idea:
Key Idea #4: Fear causes more fear.
Typically, in times of highly emotional and tense environments, people by default will act first and ask questions later. In this instance, depositors and investors will likely want to withdraw their money or sell off their investments immediately. This is called a 'bank run'.
This then creates more problems for banks, because they will have to also sell their bond investments to fund the withdrawals being made.
When a bank is unable to fund withdrawals, it then causes more panic in the market, causing more withdrawals and it just becomes a cycle of fear and sell-offs.
With that, let's now go do the most important part...
How Does All This Affect Us?
I'll answer this question in two ways: first as depositors, and second as investors.
The Impact for Depositors
As depositors in Singapore local banks, what is happening in the US really has no foreseeable impact yet. My general opinion is that the Singapore population is generally very conservative when it comes to investments so there is a huge amount of assets remaining in time-deposits and fixed income securities with longer term maturity.
Additionally, if ever liquidity would be the problem (and we are very far from it), there is a very high chance that the Singapore regulator will find a solution.
In other words, there is no cause for any alarm, to suddenly want to withdraw deposits.
As for depositors outside the US, we'll have to wait and see because we don't know the exact ripple effect. Generally, if the majority of the depositors' accounts in the bank are below a certain threshold, then they are insured and so, there's no need to worry. But, this will vary from bank to bank. The insured deposit limit per country also differs.
The Impact to Investors
From an investor standpoint though all this fear in the market is actually creating a huge opportunity.
According to Warren Buffet, "invest when others are fearful, be fearful when others are greedy".
And it is clear that there is a LOT of fear in the market.
So here are my general thoughts as an investor...
(Note: to my clients, we can always talk 1:1 for more customized recommendations as we consider your financial goals, budget, and risk tolerance too.)
- For Long Term Investors with a 5-10 year timeframe. Take this time to accumulate more, at lower prices. There is always a ton of opportunity for wealth building during a recession, and I expect that those who invest the most in these next 1-3 years are going to be setting themselves up for a windfall when the market recovers.
- For Existing Investors who have capital to deploy, continue to dollar cost average. There is no need to time the 'bottom' of the market, because prices are already hugely discounted at this time.
- For those who have not started with their investments and want to start now, then I recommend to seriously think about financial planning first. This way, you can invest with clarity and certainty in alignment to your financial situation, goals, risk appetite, and timeframes.
Do Not Wait to Invest, It is Wiser to Invest then Wait!
One thing I'd like to emphasize amid all these news is that investing now (or at least in the next 3 months or so), pretty much guarantees that you will not miss out on the upside when the market recovers.
And while it is true that prices can still drop, you can rest assured knowing that on an 'absolute sense' you were able to buy at cheaper prices.
However, by waiting and waiting and waiting, time is actually against you. The longer you wait for the market to 'settle down' or reach the 'bottom' (which no one can really predict when it will happen), the higher your chances of missing out on the reversal.
In conclusion, there's really just two things to take away from this article:
- No need to panic.
- There is a huge opportunity to invest.
With that, I hope this article helped you gain understanding and confidence in your financial decisions. If you have friends and family wondering what's going on, then please feel free to share this article!
Lastly, if there's anything you need help on, you can always reach out and I'd be happy to assist.
In the meantime, I'll be watching this situation closely and will keep on posting relevant updates and recommendations.