The US banking industry has long been recognized as robust and reliable, thanks in part to the FDIC insurance program that provides retail depositors with peace of mind about the financial stability of their chosen banks. Currently, the FDIC insurance limit is $250,000 per covered account, meaning that there is no need for retail depositors to panic or switch banks based on financial concerns.
However, there is a clear need for improvement within the banking industry as a whole, specifically when it comes to tackling the challenge posed by zombie banks.

Understanding Zombie Banks: What They Are And How They Happen

Zombie banks are those with a mark-to-market value of assets significantly lower than the value of all liabilities. In other words, these banks have negative equity on a mark-to-market basis.

In addition, accounting and regulatory capital rules allow banks to disregard the current valuation of certain assets in favor of historical values, which can result in significant discrepancies in the mark-to-market value of assets during periods of market volatility, such as sharp increases in interest rates.

The Dangers of Zombie Banks:

Despite their existence being a stopgap measure, zombie banks can become a ticking time bomb for the financial system. Here are a few risks associated with these financial entities:

1. Effect on Economic Growth: These banks divert resources that could be utilized for productive investments. These unproductive allocations hinder economic growth, stifling innovation and impeding the overall health of the financial ecosystem.
2. Moral Hazard: Governments and central banks inadvertently create a moral hazard by propping up insolvent institutions. This moral hazard arises when banks become complacent, assuming they will always receive bailouts, incentivizing risky behaviour and weak risk management practices.

The Persistence of Zombie Banks And The Need For Vigilance

While retail customers need not worry about the safety of their deposits in zombie banks due to the FDIC insurance program and the US regulatory system, however, these banks are still a cause for concern.

A December 2022 research report from the PNC Financial Institutions Group identified 30 zombie banks and 500 banks that required further analysis. This lack of market reaction to potentially troubled banks can be confusing. Still, it is essential to recognize that these banks can continue to operate indefinitely until an event requires the sale of assets with unrecognized losses.

Tackling the Issue

Encouraging healthy banks’ growth and capitalization is crucial while addressing weaker banks’ issues through recapitalization, purchase by stronger banks, or closure. This benefits the entire industry and ensures that depositors are protected in the long run. Allowing zombie banks to operate without corrective action could ultimately destabilase the entire industry.

Furthermore, market pressure on equity prices can be beneficial in encouraging weaker banks to take corrective action, while stronger banks can provide support. The US banking industry currently has around 4,500 institutions insured by the FDIC, and a little pruning of the group may be necessary to maintain industry stability.

One example of this is the failure of Silicon Valley Bank. While it would be too simplistic to claim that the failure of Silicon Valley Bank was solely due to this, it is clear that it was a contributing factor. Addressing the issue of zombie banks can prevent similar situations from occurring in the future.

The Solution – Ensuring Healthy Banks!

In conclusion, while retail depositors need not worry about the safety of their deposits in zombie banks, addressing this issue is crucial to maintain stability and growth in the US banking industry. Encouraging the growth and capitalization of healthy banks while addressing the issues of weaker banks through corrective action can ensure the long-term protection of depositors and the industry as a whole.