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Monday, May 1, 2023

Another Bank Bites The Dust

First Republic Bank was forced into a take over by J.P. Morgan Chase, and was yet another Californian victim of bad banking risk management. My bias was that First Republic was not large enough to worry about, so I cannot offer any insights into the event. My main complaint is that this appears to be another bank that blew itself up with interest rate risk, which makes my life of writing a banking primer more difficult. I had always made allowances for bad bank risk management in the United States, but I had underestimated how large an incompetent bank can get.

Other than for the unfortunate owners of securities issued by First Republic (and apparently wealthy people in San Francisco who wanted overly generous mortgages), the demise of this bank is not a big deal by itself for the macroeconomy. Instead, the issue is whether there are still other weak links in the banking system? I am not in a position to have a strong opinion on that question, but it would be a question worth looking in to. My bias is to not pay too much attention to interest rate risk — credit risk is the killer for financial systems. Although I am seeing people pointing to commercial real estate risk, I do not think I could point to a time in recent decades where somebody was not worried about credit risks in commercial real estate.

The usual worry is that the Fed hikes until something breaks — which is exactly how I describe previous cycles.1 Since the current bank failures were due to interest rate risk, we can blame them on Fed action. The question is whether these are enough to derail the economy? Although the Monetarist-inclined are worried about M2, my concern is credit growth (since Fed balance sheet shenanigans are forcing reallocations of financial assets which do not have much economic impact). One measure of credit that I like — commercial & industrial (bank) loans outstanding (above) — has rolled over.

As can be seen in the chart, C&I loans rolling over only tended to happen in recessions. However, we did see a lack of growth in the mid-2010s without a recession (circled episode), so I would be cautious about panicking.

I am not in the forecasting business, and do not want to be calling for recessions every six months. Although there are certainly negative vibes, one can still argue that they are consistent with a “soft patch,” which is a part of lengthy modern business cycles. You pays your money, and you takes your chances.


There is a survivorship bias in that observation. It could be explained by (1) business cycles being typically ended by financial fiascos, and (2) the Fed tending to hike rates until the expansion ends, with (1) and (2) being independent.

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(c) Brian Romanchuk 2023

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