Could this banking crisis be short-lived?
It’s not over, but it’s safe to say the feedback loop is now breaking. Swift action by the Fed, US Treasury, FDIC, and other institutions was critical. That said, the fear persisted last week with the Credit Suisse and First Republic sagas. The supportive actions taken for these two banks, a $54 billion loan to Credit Suisse from the Swiss National Bank and the brokered deposit injection into First Republic from a consortium of 11 major US banks helped to further quell the fear of the acute crisis phase.
But just because the acute panic phase may be over, and this does not appear to be a repeat of 2008, doesn’t mean it’s all smooth sailing for the banking sector and the broader economy.
How might the crisis impact the economy?
At a macro level, there are likely to be some lasting effects. The banking sector will likely tighten lending as small banks in particular refocus on shrinking their balance sheets and prioritizing liquidity as the cost of capital rises. This isn’t a death blow to growth as large banks are likely to pick up some of the slack from the cutback in lending at small banks. The net effect is likely to prove disinflationary.
The Fed will certainly take some disinflationary help in tightening credit conditions, and while policy rates are still likely to remain higher for longer, the ceiling on the terminal federal funds rate may now be lower than it would have been otherwise.
For the banking sector, the crisis fears are likely to give way to profitability fears. Indeed, large money center banks have already benefited from deposit inflows and may not need to compete as aggressively with rates to hold onto deposits. But competition comes from outside of the banking system, as well. For example, money markets offer more attractive rates that continue to find their way in the Reverse Repo facility, thereby extracting deposits from the banking system and removing another source of funding in short-term commercial paper. Loss provisions will also likely grow for all banks as assumptions for lower growth are factored in, providing another headwind to the bottom line.
Overall, the crisis phase appears to be closing, and while the mainstream narrative is likely overly pessimistic with respect to growth implications, the effects will continue to be felt in markets and the broader economy.
Is SVB a one-off or systemic issue?
Silicon Valley Bank is a unique issue. Its deposit base is largely tied to tech startups, which have a high cash burn rate. As the Fed hikes bite into the areas of the economy that have benefited the most from cheap financing (high tech start-ups, crypto-related firms), it should not be surprising that those deposits get eaten up rather quickly. SVB has 15% tier 1 capital, 40% loan to value, and 100% deposit liquidity coverage. A typical bank during the global financial crisis? Tier 1 capital was single digits. Loan to values were much higher, and balance sheets were stuffed with collateralized loan obligations, asset-backed securities and other riskier assets.
So, interest rate hikes and a business that catered to a specific segment of the economy (one that was highly leveraged to the tech bubble that is now deflating) made for a perfect storm. Add in some management missteps and this helped to accelerate trouble.
Yes, it's easy to draw up 2008 global financial crisis analogies. But the reality is that today is nothing like that. 2008 was a credit crisis that led to a significant erosion of bank capital, driven by bad loans made to the real estate sector. Today is about interest rate risk and deposit flows which have largely been addressed by the recent actions taken by authorities.
How have the Fed and other institutions helped to alleviate the situation?
The Fed’s new Bank Term Funding Program (BTFP) is a powerful backstop that should restore confidence in the banking system. While the Fed stands ready as the lender of last resort, banks have been tapping liquidity from the lender of next to last resort – the Federal Home Loan Banks. Over just this past week, the FHLB has issued nearly $250 billion in debt to provide liquidity to regional and community banks. We will certainly be watching for any further issuance.
What is the Fed’s new Bank Term Funding Program?
Only three Marches removed from the Covid crisis that saw the Fed unveil new emergency facilities – we have yet another opportunity to see the Fed’s emergency toolkit at work. Enter the Bank Term Funding Program, which went live March 12. The purpose of the program is to provide an additional source of liquidity to eligible depository institutions to ensure banks have the ability to meet the needs of all their depositors by accepting high-quality securities as collateral against loans in order to avoid the need for a bank to quickly liquidate those securities in times of stress.
Any US federally insured depository institution or US branch or agency of a foreign bank that is eligible for primary credit at the Federal Reserve’s discount window is eligible for the program. BTFP will offer loans of up to one year in duration to banks, savings associations, credit unions, and other eligible depository institutions. In return for the loan, banks will pledge eligible high-quality assets as collateral, such as US Treasuries, US Agencies, and US agency mortgage-backed securities. Critically, these assets will be valued at par, as opposed to their mark-to-market values. This maximizes the capacity of banks to borrow from the facility in the wake of the sharp rise in rates over the past year.
Will the Fed put rate hikes on hold now?
Given the bank failures this March, and a jobs report that was actually not all that hot when looking at the internals of the number, the Fed certainly has grounds to hike 25 basis points and talk hawkish versus hiking 50 bps at the next meeting March 21–22. They have stressed being data-dependent all along. The size and speed of the recent rate hikes (we are still just 12 months in from the first hike and 450 basis points higher!), as well as these recent developments, might cause the Fed to chill things out a bit.
These recent developments will certainly tighten financial conditions at the margin. Moving more aggressively with rate hikes could very easily exacerbate the issues going forward. Markets have aggressively repriced the interest rate outlook over the past week. As of March 18, futures trading implies a 74.5% probability of a 25 bps rate hike by the Fed and a 25.5% chance of no hike at all. The odds for a 50-point hike are now effectively off the table.
Where do markets go from here?
While it is tough for many investors to dive right back into risk assets, we think this episode likely proves to be longer-term deflationary, nudging the Fed towards a less aggressive stance. Despite the headlines, stocks have proven to be quite resilient in the face of this uncertainty. While stocks have bounced around, the S&P 500® started the month of March at 3,951 and ended the week (March 17) at 3,917.
Uncertainty? Yes. A financial crisis and deep recession? Not so sure. Overall, the crisis phase appears to be closing, and while the mainstream narrative is likely overly pessimistic with respect to growth implications, the effects will continue to be felt in markets and the broader economy for some time.
A reverse repurchase agreement (RRP), or reverse repo, is the sale of securities with the agreement to repurchase them at a higher price at a specific future date.
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