The recent demise of Silicon Valley Bank and other financial institutions shows the exposure of U.S. banks to higher interest rates has significant implications for financial stability.

In his recent research, Tomasz Piskorski, the Edward S. Gordon Professor of Real Estate in the Finance Division at CBS, examines the challenges banks now face and the potential implications for the broader economy.

Watch the video above to see Professor Piskorski discuss his latest research, or read a summary below:

 

CBS: Tell us about your latest research.

Tomasz Piskorski: Recently, I have been examining the repercussions of the Federal Reserve Bank's aggressive monetary tightening on the financial stability of U.S. banks. Due to the rapid increase in interest rates, we have observed a decline in the value of bank assets by approximately $2 trillion compared to previous levels. As a result, nearly half of all U.S. banks now possess assets with market values lower than the face value of their liabilities. It is important to note that not all of these banks are insolvent; their status depends on the behavior of the depositors, who constitute the vast majority of bank funding. Particularly, uninsured depositors are at risk of losing their funds if a bank were to fail. Our analysis reveals that a specific rate of withdrawal by insured depositors could potentially lead to the failure of anywhere from 200 to up to 1,600 banks.

CBS: What other risks are out there?

Piskorski: The primary analysis focuses on the impact of high interest rates on bank solvency. However, we have not yet delved into the assessment of credit risk. This is the core objective of our follow-up research. We investigate the outcomes when a portion of commercial real estate loans default at each of the US banks. Why concentrate on commercial real estate? This sector is currently under significant stress, particularly the office segment, influenced by factors such as remote work, elevated interest rates, and potential weakening demand due to events like tech layoffs. Our findings reveal that due to the rising interest rates and the erosion of asset values within US banks, they are now situated in a much more vulnerable position. In reality, an additional number of banks could face potential failure as a result of the distress in the commercial real estate sector. It's worth noting that had this distress materialized one or two years earlier, the situation might have been less problematic.

CBS: What could all this mean for the economy?

Piskorski: The main conclusion drawn from our research is that the U.S. banking system is currently in a highly fragile state. This situation holds significant implications for the U.S. economy, particularly if banks were to reduce their provision of credit to households and businesses. In response to the crisis, federal authorities intervened by extending credit facilities to banks and, in some instances, providing deposit guarantees. This intervention effectively prevented widespread bank failures in the short term. However, this action also implies that the most vulnerable banks will need to be either closed down or potentially merged with other institutions.

In the long term, the ongoing crisis is likely to have a substantial impact on financial regulation. At the very least, federal authorities should emphasize the banking sector's readiness for potential increases in interest rates. Additionally, there will likely be a push for enhanced risk management practices within banks. One plausible solution could involve mandating banks to augment their capital buffers, thereby enhancing their resilience against future interest rate hikes or similar shocks.