Professor says the business model of banks is inherently fragile

Professor Rahul Vashishtha Image: Courtesy Fuqua

On May 1, 2023, First Republic Bank was seized by the Federal Deposit Insurance Corporation (FDIC) and acquired by JPMorgan—the last of a string of three regional bank failures in less than two months.

However, many analysts pointed out substantial differences from the earlier failures of Silicon Valley Bank and Signature Bank, and attributed First Republic’s demise to a textbook bank run, a panic-based rush to withdrawals that might not have much to do with the health of the bank.

“Runs could bring down even a fundamentally solid bank,” said Rahul Vashishtha, an associate professor of accounting at Duke University’s Fuqua School of Business.

In a presentation on Fuqua’s LinkedIn page, Vashishtha spoke about how an inherent fragility of the banking business can trigger runs, and how some accounting rules about the fair value of loans might make matters worse.

The fragility, he said, is linked to what scholars call the liquidity transformation of the bank business model.

“Banks are in the business of taking deposits and handing out loans,” Vashishtha said. “Loans facilitate investments, and help people buy houses. Deposits, similarly, are very important because they offer a temporary parking place for people’s cash.”

But in using deposits to make loans, banks transform a liquid asset into an illiquid one.

“If a bank needs to sell the loan, because depositors are requesting their money back, they might have a hard time to find a buyer,” he said. “And even if they do, they might not get a good price.”

Also read: Is transparency making banks more fragile?

What’s causing panic runs

Vashishtha explained panic runs may not be triggered by concerns about the health of the bank.

 “Most runs are just driven by the fear of withdrawals by other depositors, and these kinds of fears can turn into self-fulfilling prophecies,” he said.

In a paper, Vashishtha and his Fuqua colleague Qi Chen outline “a significant presence of panic runs in U.S. banks holding a lot of illiquid assets.” Commercial mortgages are one example. The researchers also found more runs occurred in banks with relatively lower percentages of insured deposits. In the U.S., the FDIC insures deposits up to $250,000.

Vashishtha acknowledges that some withdrawals might be driven by reasonable concerns about the bank’s solvency and how it is managed. But his research points to the unintended effect of the 'fair value' accounting disclosures, which he says may have played a role in the 2023 banking crisis.

Vashishtha said the fair value of a loan is roughly what a potential buyer would be willing to pay if the bank has to sell it now. “It’s the exit value,” he said, which can be lower than the value of the loan if held to maturity.

The problem is that the fair value “can be influenced by factors that don’t have anything to do with the quality of the loan,” Vashishtha said. Interest rates, for example, negatively affect the selling value of a loan. In the context of one of the biggest Fed’s rate-hike campaigns in recent decades, banks were taken by surprise, he said.

“Higher interest rates generated unrealized losses sitting in the fair values of banks’ loans,” Vashishtha said. “And these unrealized losses have the potential to trigger panic.”

Before its collapse, First Republic Bank had nearly $136B worth of mortgages in 2022, which accounted for a fair value of about $117B, Vashishtha said. “Is that $19 billion difference a big deal? The answer is an emphatic yes.” Vashishtha says that’s because the bank’s shareholders equity was $17 billion.

“If First Republic had to liquidate its assets, the whole equity would be wiped out,” Vashishtha said.

He believes policymakers should consider redesigning the fair value rules.

In their current form, these disclosures don’t seem to convey much information about quality, Vashishtha said. “All they seem to be doing is triggering panic in markets.”

[This article has been reproduced with permission from Duke University's Fuqua School of Business. This piece originally appeared on Duke Fuqua Insights]