Insight

US bank failures, the government response, and implications for markets

US bank failures, the government response, and implications for markets
Key Takeaways:
1

Banks are facing macro headwinds from higher deposit rates, lower margins, inverted yield curves and an increasing risk of recession.

2

Some of the key issues arising in the crisis have been addressed in the US government’s policy response.

What happened?

Several banks in the US came under extreme pressure last week. These pressures had been building for some time, driven by aggressive central bank tightening. 

  • Silvergate Capital, which is closely tied to the digital asset industry, announced it would shut down, having experienced significant deposit outflows from its clients as cryptocurrencies came under pressure.
  • Silicon Valley Bank (SVB) announced an equity capital raise on Wednesday because of losses in its “available for sale” portfolio, which it had to sell to meet a high level of redemptions brought on by tighter lending conditions and tech industry headwinds. After an unsuccessful attempt to sell itself, Silicon Valley Bank was shut down on Friday by regulators.
  • Over the weekend, regulators shut down Signature Bank.

Fortunately, the response from policymakers over the weekend was swift and powerful. The US government announced on Sunday a new facility for managing this banking crisis — the Bank Term Funding Program (BTFP). The BTFP will allow banks to meet customer withdrawals by borrowing from the Federal Reserve, using their bond portfolios as collateral without having to sell securities at a loss, as Silicon Valley Bank had to do. 

Federal regulators also announced that depositors of Silicon Valley Bank and Signature Bank would be paid in full. This addresses the problem of contagion created by the crisis, and therefore should help contain risks to the financial system as a whole. In other words, the liquidity crisis for these banks — which caused a solvency crisis and could have spread to more regional or specialized banks (which, of course, has echoes of the Global Financial Crisis) — is likely to be averted by the rapid and comprehensive policy response.

This new facility addresses — at least temporarily — some of the problems created by the rapid tightening of a very accommodative monetary policy environment. Banks under significant pressure can obtain loans for bonds based on par value (rather than market value) — likely shifting just how many insolvencies may be out there. It must also be recognized that regulators had fostered the notion that government bonds could be treated as (credit or default) risk-free, thus encouraging banks and other institutions to rely upon them to boost risk-weighted capital ratios. But government bonds clearly are exposed to significant price risk and thus can create major losses (if they cannot be held to maturity but are not marked-to-market). This facility is a direct consequence of that regulatory decision.

How have markets reacted? What is our take on what is happening? 

The market response was very negative on March 8 and 9, with stocks selling off and the 2-year US Treasury yield falling the most since 2008. There were fears that this may not be an isolated incident but could be the start of contagion given that other banks could be in a similar position to Silicon Valley Bank, being forced to sell assets at a loss to cover deposit withdrawals. 

Investors were rightly concerned about the impact of large potential mark-to-market losses on banks’ balance sheets, which the FDIC estimates at $620 billion1. In addition, there were concerns that there could be knock on effects for some tech and biotech companies. Silicon Valley Bank is the banking partner to about half of US venture-backed technology and life sciences companies2 and many of these companies would not be able to access their cash to meet payrolls and other obligations once Silicon Valley Bank was shut down.

However, the US government’s policy response announced on Sunday, March 11 helped to improve market sentiment. Equities rose, although high yield has shown more stress. 

We are encouraged by the US government’s forceful and quick response to the crisis. We believe these banks’ liquidity and solvency issues illustrate the risk of unintended consequences when central banks make abrupt changes in policy. It may also make central banks more cautious about further tightening, especially if their mandates require them to maintain financial stability alongside reaching their inflation targets.

What is our outlook on the situation? 

We believe the events of the past week reinforce the view that the “Fed put” is alive and well. It seems unlikely that the Fed can raise rates much more, although this new facility could give the Fed a greater ability to continue raising rates than it had on Friday. 

The good news for now is that regulators are responding rapidly to evolving market conditions and doing so in a prudent way by allowing banks to fail, while keeping deposits safe. This is likely to stop runs in more internationally important banks, which potentially stand to benefit from a flight to safety. 

We do think there is a risk that banks, insurers, or other holders of long-term fixed income assets — whether in the US or in other regions — may face similar issues. Of course, the ongoing decline in bond yields, if it becomes a trend, should help cushion this problem. Given much tighter supervision, regulation and capitalization of the money center banks, financial breakdowns have been isolated so far and seem likely not to become systemic, though that risk has risen.

Furthermore, if there are significant liquidity shortages in important parts of the financial system globally, we would not be surprised to see the Fed re-introduce dollar swap lines that have become an occasional feature of global financial management during and since the Global Financial Crisis.

What is our resulting market perspective? 

To the extent that banking sector confidence has been shaken, there may be a lower supply of credit to the US economy, in turn slowing economic growth (and probably inflation too), increasing the risk of recession. If lower expected rates continue and the Fed is 25 to 50 basis points from the terminal rate, then it implies a weaker USD and outperformance of long duration assets and emerging markets (assuming the banking crisis is limited to the US). Oddly enough, it can support US equity markets with a higher exposure to the growth factor and weaker dollar translating into higher earnings for multinationals.

We expect volatility in the near term, given there is significant uncertainty around the Fed’s path going forward. We will get far more clarity from the next FOMC meeting and the dot plots issued at that meeting.

What are we watching out for? What are the risks to our view? 

We have to recognize there is a possibility that inflation remains persistent in the US despite the tightening in market conditions caused by this financial accident. And there is also the risk that the Fed’s actions in containing the fallout from SVB and Silvergate ease financial conditions as markets reprice towards fewer rate hikes or an earlier pivot to rate cuts. In this scenario, the economy could once again re-accelerate, shoring up a still tight labor market and contributing to stickier inflation pressures. The Fed might then need to resume tightening once again.

Either way, the path of inflation moderation going forward may not be satisfactory enough for the Fed to hit the “pause button” or start to pivot to easier policy soon. The February US jobs report was robust — even though wage growth was below expectations, new jobs created were above expectations. And while US CPI was largely in line with expectations, the Fed may still be uncomfortable with core services ex. housing inflation which remain significant. A prolonged or renewed tightening cycle could increase pressure on the banking sector, increasing recession risks and delaying the time before a sustainable economic recovery could start. 

Footnotes

  • 1

    Federal Deposit Insurance Corporation

  • 2

    Source: Kinder, Tabby et al., 9 March 2023, Silicon Valley Bank shares tumble after launching stock sale, Financial Times, https://www.ft.com/content/69b70b4b-efeb-42c4-8882-c133f92d8356 

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