Last week brought the failure of a three small US banks. This triggered discussion of bank debt problems, particularly how difficulties at one bank could potentially spread to others if it was unable to repay money owing to them on time.
Banks are superficially simple businesses. They borrow from one group of people and lend to another group, earning an interest margin between the two. All is well until some borrowers fail to repay on time. Then the bank may be unable to repay the depositors it borrowed from.
If a bank is in trouble with slow re-payers it may also have trouble repaying other banks that it borrowed from. So bad debt contagion between banks can be real. Bad debts must be budgeted for and managed.
The best plan for a bank is to lend very carefully so it doesn’t get caught by non-payers. The largest US failure, Silicon Valley Bank, specialised in lending to California based technology companies. Many aren’t profitable yet so this was obviously a high-risk strategy.
The big increases in interest rates in Australia and around the world are likely to cause an increase in slow payers and non-performing loans.
Our banks make substantial provisions for bad and doubtful debts. Australian regulators insist that our banks hold high levels of high-security liquid reserves so they can cope with a significant level of bad debts. This provides a very high level of security.
In the US there are hundreds if not thousands of banks. A few are very large but most are smaller. This diversity provides far more opportunity for small failures to develop, potentially spreading to others.
Silicon Valley Bank’s strategy of providing credit to new technology start-ups was obviously brave. Most mainstream banks would avoid such activities and minimise any involvement with other lenders who engaged in that business.
Fortunately, the US authorities and Federal Deposit Insurance Scheme stepped up and guaranteed all deposits at Silicon Valley Bank. Their main aim was to prevent bad debt contagion spreading to other banks.
Australian banking is dominated by several large operators. This means less risk of system instability. Our banks also benefit from a Government guarantee of the first $250,000 in each account. So the chances of loss of consumer confidence causing a run on a bank are extremely low.
One likely consequence of the US bank wobbles is that interest rates are likely to stop increasing sooner. Future increases will be small because central banks will now be much more fearful of raising rates too far and causing bad debts, bank failures and recessions.