The stock market continued to lose ground on Friday, adding to steep losses from Thursday's session. As of 1 p.m. EST, the Nasdaq Composite (^IXIC 0.63%) was leading the way lower by more than 1%, while other major benchmarks had smaller but still significant declines on the day.

Many investors had anticipated that the latest employment report would end up getting the lion's share of attention from the broader stock market. However, regional banks came into the spotlight instead, as investors reacted to the news of one bank voluntarily liquidating while another was seized by the Federal Deposit Insurance Corporation (FDIC). Many bank stocks saw substantial losses as a result.

Person at a bank counter with cash on the desk.

Image source: Getty Images.

Carnage across the banking industry

The problems started earlier this month with Silvergate Capital (SI 1.21%) as it found itself unable to recover from a massive outflow of deposits following the collapse of cryptocurrency exchange FTX. Silvergate agreed to liquidate its banking subsidiary voluntarily as other clients chose to discontinue their banking relationships.

Then earlier this week, SVB Financial (SIVB.Q) encountered problems raising capital. The steep rise in interest rates caused losses in its securities portfolio, but demand for cash in the wake of tough business conditions in its Silicon Valley focus area forced SVB to try to raise capital. When it couldn't do so, it sought a buyer for the entire bank, but when those efforts failed, the FDIC took over its Silicon Valley Bank subsidiary.

The combination of those two factors has investors looking closely at banks across the industry, not just those most closely associated with cryptocurrency or venture capital. Western Alliance Bancorporation (WAL 0.46%) suffered a 39% decline in its stock price Friday afternoon, while PacWest Bancop (PACW) was down 30%, and First Republic Bank (FRCB) fell 18%. All three of these banks have exposure to the West Coast, and investors clearly believe that there's heightened risk of banking-related losses in the region.

Will the Fed stop now?

The problems in the banking industry have revealed a problem with the Federal Reserve's aggressive series of interest rate hikes that many hadn't realized before. The rapid increase sent bond prices falling sharply in 2022, and that in turn left banks with unrealized losses on their balance sheets.

That wouldn't necessarily have been a problem if depositors had left their money in those banks. However, when customers sought to withdraw their money, it forced banks to sell off their assets in order to raise the cash. That in turn realized those losses, making them permanent and creating challenges in capital management.

The St. Louis branch of the Federal Reserve had identified this as a potential problem in early February. In a blog post, the St. Louis Fed noted that falling bond prices caused more banks to see tangible common equity fall to below 5% of tangible assets, making it harder for those institutions to conduct business or raise funding. Although regional banks typically have access to the Fed's discount window, relatively high interest rates make it a more costly option than attracting normal deposits.

Because of these banks closing their doors, some investors now believe the Fed will stop hiking interest rates as aggressively. Bond prices have jumped Friday, sending rates down and reflecting the hope that a feared half-percentage point rate hike might now no longer be on the table.

That might be the case, but the real damage to bank balance sheets has already been done. In the long run, investors now have to worry that pressure on the banking system might prevent the Fed from doing enough to stop high inflation from becoming entrenched in the economy -- a problem with much larger consequences if left unchecked.