This past week was a week of shocks and market volatility. Early in the week, Federal Reserve (Fed) Chairman Jerome Powell stated that the Fed was prepared to speed up interest rate increases if the data warranted, and that the peak rate would be higher than previously anticipated. Markets took this as a willingness to hike rates by 50 basis points (bps) at the next policy meeting, if needed. Then on Friday, the Federal Deposit Insurance Corp. (FDIC) put Silicon Valley Bank (SVB) into receivership. The failure of SVB, fears of “higher for longer” from the Fed, and a general tightening of financial conditions were more than enough to offset another solid month of US employment gains, leading investors to fret that US economic growth might stall by year end.
Even worse, as large depositors realized that the FDIC was not prepared to insure its holdings at SVB, jitters spread over the weekend that other banks might experience depositor flight. Fears of bank runs prompted a significant policy response. Late Sunday afternoon, the US Treasury, Fed and the FDIC announced that all depositors of the failed SVB and a second bank failure, Signature Bank, a key bank to the cryptocurrency industry, will have access to all their money starting Monday, and that other measures would be taken to ensure adequate banking liquidity nationwide. Their aim is to prevent a single bank failure from becoming another financial crisis.
As this remains a fluid situation, I wanted to get out some preliminary thoughts. I will continue to update my commentary as the situation evolves.
- Accelerated outflows at SVB required the FDIC to step in. Like all banks, SVB had illiquid assets (loans) and liquid liabilities (deposits). As important segments of its depositor base (i.e., entrepreneurs) began to see their funding from other sources (e.g., venture capital) dry up, their need for cash forced them to withdraw deposits from SVB. To meet that demand for cash, SVB was forced to sell holdings of US Treasuries. Given the sharp rise in interest rates and fall in bond prices over the past year, those sales resulted in significant losses for SVB. When those losses were revealed to be nearly US$2 billion, deposit outflows accelerated, requiring the FDIC to step in, close the bank, and reopen it under a new name (National Bank of Santa Clara–NBSC).
- Share price of other US banks impacted. When it closed SVB on Friday, the FDIC has announced that deposits of US$250,000 or less would be guaranteed, but deposits of over US$250,000 would receive “certificates” whose value would depend on the recovery rate of SVB’s assets. That decision made large depositors at other US banks not designated as “systemically important banks” nervous, apparently resulting in the start of significant depositor withdrawals from many smaller banks nationwide. Investors, recognizing that risk, had already sold off shares of smaller and mid-sized banks—those most at risk—late last week. Meanwhile, for the technology sector, the potential losses of commercial depositors at SVB suffered were potentially significant, and risked putting added pressure on the tech sector, which has already suffered a slowing of activity and employment.
- Systemic risk was emerging. By this weekend, it was clear that what was originally thought to be an isolated bank failure posed a systemic risk to the financial system. That resulted in the aforementioned actions of the regulators to stabilize the situation. With respect to SVB, the FDIC will complete its resolution of the bank in a manner that fully protects all depositors. Simultaneously, with the approval of the US Treasury Department, the Fed will initiate a new Bank Term Funding Program aimed at providing adequate emergency funding to any bank suffering significant depositor withdrawals.
- This is not new. It is worth underscoring that almost all financial crises have begun with what appears to be an idiosyncratic event (recall Bear Stearns MBS hedge funds in 2007), that ultimately reveals more systematic risk at work. The same was unfolding as a result of SVB’s failure, but this time the authorities are taking decisive steps to prevent significant dislocations to the US banking and financial systems.
- SVB was different. Not an ordinary bank, SVB’s deposits were concentrated in the technology sector, making it more vulnerable to sudden withdrawal than would be the case for more liability diversified banks. It also held a significant fraction of its assets in the form of inadequately hedged Treasury securities. Hopefully, most well-run banks have hedged their holdings of Treasuries in ways that SVB apparently did not. But that, alone, may not shield them from depositor outflows if confidence wanes. Banks—the good and the bad—exist on the basis of depositor confidence, a lesson SVB’s collapse hammered home.
- Loan losses could prove problematic this year. Shoddy lending did not bring SVB down. But that does not mean that other banks won’t experience deteriorating asset quality in the months and quarters to come. Banks exposed to subprime auto loans and leases, or to commercial real estate, areas of lending already flashing “amber” in the eyes of many credit analysts, bear watching. But it isn’t easy. Banks are opaque institutions and loan (asset) quality is notoriously difficult to track. Deposit flows, on the other hand, can be monitored and are reported on a high-frequency basis to the FDIC, the Fed, and others. Any deposit “run” will therefore be handled in real time—as we are now witnessing again—but loan losses could prove problematic this year, particularly if the Fed’s tight monetary policy stance pushes the economy toward recession.
- SVB’s failure could change the Fed’s tightening stance. To the extent that the SVB problem is now under control, then barring an unexpected decline in inflation this week, the Fed may hike rates 50 bps at its March 21-22 policy meeting. But if the situation remains volatile and uncertain, then the Fed will be conflicted and may be forced to do less (25 bps) or even skip a hike at the upcoming meeting.
- Money market funds ought to be better positioned than during the global financial crisis due to regulatory changes. Having said that, the average investor may become concerned, insofar as many of them probably do not realize the difference between assets held in custody by an asset manager and deposits held at a bank.
- For financials stocks in general and banks in particular, it may take longer for equity multiples to recover. Bank stocks are likely to leap up on Monday with the latest news. However, there is likely to be reluctance among some investors due to lingering concerns about bank balance sheets and the opacity of the financial sector.
Finally, SVB has underscored one thing: This is going to be a volatile year.
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