The Silicon Valley Bank (SVB) debacle shows that the effects of monetary tightening take time to reverberate through the economy and that the vulnerabilities associated with an aggressive tightening phase often show up in unexpected places. If central banks embrace a higher-for-longer stance, they must exercise caution to ensure its sustainability. In the US, the unfolding situation seems unlikely to affect the larger banks, while there are likely nervous days ahead for smaller banks. In Europe, on the other hand, post-Global Financial Crisis (GFC) regulatory resilience has kept banks in decent health.
For many months, the Federal Reserve (Fed) has been complaining that financial conditions have not tightened enough despite aggressive interest rate hikes that have so far totaled 450 basis points. And we have been stressing that there is a significant difference between the cost of capital, which has risen to a point of being now restrictive, and outright market stress, which is what typically causes financial conditions to spike. We had also been arguing that the Fed should focus on the first task and allow the higher cost of capital to work through the economy, a process that—inevitably—will take time (Figure 1).
Given little signs of de-anchoring of inflation expectations, a degree of patience is warranted to preclude a non-linear event that could dramatically alter investor sentiment and might even force an undesired reversal in policy direction. If the Fed wants to keep interest rates elevated for an extended period of time, care must be given that they are not so elevated as to become unsustainable. This is why we had long favored a dovish stance in respect to the terminal Fed Funds rate (expecting a peak Fed Funds of 5.0% with a last hike in March).
While the situation is extremely fluid, we still favor a 25 basis points hike next week, although we would hope it would be accompanied by signals that the end of the hiking cycle is at hand. Clearly, the inflation battle has yet to be won, but it is in the process of being won and in light of new emerging risks, perhaps that is good enough for now. We continue to anticipate a sharp decline in inflation over the remainder of the year and had long held an out of consensus view calling for a cut in December. Recent data strength had put a lot of question marks around that timing, but the latest developments once again suggest that view is not as outlandish as it might have seemed just a week ago.
We have similar concerns around the European Central Bank’s (ECB) policy, although from more of a prospective basis in that the priced in tightening appears quite onerous. Or it did as the situation stood mid-last week: much has changed in respect to assumed tightening path since then.
The whole episode is an ironic reminder that one has to always be careful about what they wish for: there is nothing like a bank run to trigger a tightening of financial conditions. It is one thing for banks to not want to lend, and quite another for them not to be able to lend because they have gone under. Now that the non-linear risk event has occurred, the first order of business is to contain the damage.
There are many risks lurking here. Doing too much and being too generous – and our view is that some elements of the newly announced response package verge on this – will worsen the moral hazard problem and fail to ensure that a degree of market discipline is enforced across all groups of market participants – not just stock and bond investors, but also depositors.
While discussing moral hazard, one cannot overlook the fact that it is not only monetary policy but also fiscal policy that can have that effect. Liquidity injections into an economy happen via both channels and there have been plenty of both in response to the COVID-19 crisis. In retrospect, both can be described as too much. Nobody can turn back time, but one can hope that past mistakes can lead to better policy calibration in the future.
Yet, it would be disingenuous to claim that there had not been any warning sign that stress was building. After all, the Bank of England dealt with a stress episode that quickly precipitated systemic risks last summer and FTX went under several months ago. With that in mind, we will now discuss the implications of the SVB’s fallout for the US and the European banking sector.
We know that the immediate cause of SVB’s collapse was a run on the bank by depositors. The main focus in the US sector is on the unrealized losses on SVB’s held-to-maturity (HTM) book that, to be fair, were well known but grew over times as market rates rose. This is now a red flag for other banks.
The notion is that deposit outflows could use up other sources of liquidity and force banks to sell securities at a loss, driving a need to raise capital. The systemic issue still facing the sector is that securities and loans on the balance sheet will continue to lose value as the long end of the yield curve rises, assuming we are in a higher-for-longer environment.
It is also useful to note that SVB’s deposits were largely uninsured business deposits, over US$1 million on average by client, and were concentrated in a tight-knit industry that press reports indicated contributed to the deposit run by spreading panic very quickly amongst themselves.
Contagion seems unlikely to affect the larger banks or cause a systemic issue, but it is still nervous days ahead for smaller banks. Signature Bank failed on evening of March 12, driven by a deposit run. Deposit runs are emotional and impossible to rule out, yet large, systemic banks have more liquidity, larger and broader deposit bases, and a higher capacity to absorb unrealized securities losses.
For now, the favorable and quick resolution for uninsured depositors of SVB and Signature by the Federal Deposit Insurance Corporation and the new Fed facility for other banks should help increase the liquidity in the systems and improve depositor sentiment.
Longer term, increased regulation and higher costs are a likely outcome for the industry.
European banks have operated in an environment of negative/low yields up to the first rate hike of the ECB in July 2022. They have therefore kept liquidity high and are now able to extend duration and benefit from material increases in yield. Liquidity ratios (LCR) improved by about 20 percentage points through the period of December 2019 to 2021 when the market witnessed a massive central bank liquidity boost and LCR ratios now stand at an average of 160% versus the US average of about 120% (Figure 2).
One can question the quality of the LCR ratios, but the difference is material enough to show the tough regulatory environment European banks had to accommodate in their positioning. European banks have €3 trillion in central bank deposits, about 22% of the deposit base, and bond portfolios are on average 20% of total deposits.
The regulatory environment in Europe has been on a hawkish trajectory since the GFC. This has finally positioned European banks to be in relatively decent shape. European regulators have scrutinized banks’ interest rate risk in the banking book through a number of stress tests and, hence, unrealized losses on HTM securities portfolios as percentage of the total book value stand at an average of 5%.
All European banks regardless of size (under International Financial Reporting Standards) must show unrealized losses on their available-for-sale securities in both book value and capital ratios. Capital levels have doubled since the GFC and most banks are now increasing dividend yields and share buy backs, so share count is going down for the first time ever. Meanwhile, ECB’s quantitative tightening program has so far run at a much slower pace than the Fed’s, which should provide European financials more flexibility to manage their balance sheets.
The fallout of SVB and the subsequent failure of Signature Bank warn us of non-linear events that could precipitate in the context of the higher-for-longer environment. This warrants caution, especially from the part of the US Fed, now that deposit runs are impossible to rule out for US regional banks. European banks, on the other hand, have higher liquidity ratios and are now in a position to extend duration and benefit from material increases in yield.
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