No Longer Banking on Easy Money
A prolonged period of ultra-low interest rates encouraged complacency and risk-taking across financial markets and the broader economy. There had to be payback. Now, as policymakers ramp up rates to combat inflation, some vulnerabilities have risen to the surface, most recently in the banking sector.
Indeed, an era of easy money created dry tinder for financial stresses. The Federal Reserve’s sharp policy reversal lit a match that has begun to produce some unpredictable fallout. In March, two large regional banks — Silicon Valley Bank and Signature Bank — abruptly collapsed, while a third — First Republic — required a $30 billion cash lifeline. A crisis of confidence erupted, spawning a run on deposits at many other regional institutions. Smaller banks lost over $100 billion of deposits in the week after the collapse.
While not officially designated by regulators as “systemically important”, the demise of Silicon Valley and Signature marked the second and third largest bank failures in U.S. history. By assets, they had ranked 16th and 29th among American banks, respectively; First Republic stood 14th on the list. And all three companies were constituents of the S&P 500 Stock Index.
Banking math
Banks take in deposits, converting most of those dollars into loans or investments in longer-term Treasury and other government securities. In the U.S.’s fractional reserve system, only a small portion of deposits is required to be available. Therefore, a potential imbalance arises from the pairing of long-term, somewhat illiquid, assets (loans and securities) with short-term liabilities (deposits). The banking system is based on confidence. If all depositors demanded their money, banks would essentially fail.
The swiftness and magnitude of the Fed’s rate hikes have led to sizable paper losses for banks’ investments. As many of these otherwise-safe securities are intended to be held to maturity, such losses will inevitably reverse as the bonds are redeemed at par. However, if a bank must liquidate holdings prematurely to cover surging withdrawals, its capital position may be threatened.
Balance sheets across the banking sector have been impaired by the rising interest rate environment, but aggravating factors at the three troubled banks led to their downfall. For example, Silicon Valley had an outsized exposure to security losses and a very narrow, cash-burning, deposit base. And both SVB and Signature were heavily reliant on uninsured deposits for their funding (90% of all deposits). As signs of stress emerged, their customers quickly lost confidence and withdrew funds.
Firebreaks
The Federal Deposit Insurance Corporation (FDIC) quickly stepped in to fully protect all depositors of Silicon Valley and Signature, but authorities allowed those banks to fail. To prevent contagion, the Federal Reserve established a critical lending program to facilitate banks’ ability to fulfill customer withdrawals.
The Fed’s new Bank Term Funding Program (BTFP) has helped lessen the threat of banks’ unrealized security losses. It offers every federally insured institution the opportunity to borrow in full against the face value of their Treasury and agency holdings for up to a year. This initiative will help ease capital stresses from the sharp back-up in yields and alleviate pressure on banks that might be forced to sell securities at a loss to meet withdrawals.
The situation has been exacerbated by the fact that smaller banks are not subject to the stringent capital and liquidity requirements or stress tests of the very largest institutions. The BTFP should prevent a temporary liquidity squeeze from morphing into an insolvency threat. Larger banks are well-capitalized, and the odds of a broad-based financial crisis seem remote.
Banks retreat
Nevertheless, stress among small and medium-size banks will have a ripple effect through the U.S. economy. Banks with less than $250 billion in assets account for 80% of commercial and industrial lending, 45% of consumer lending, 80% of commercial real estate lending and 60% of residential real estate lending. This segment plays a critical role in the creation of credit and the economic activity that follows.
Even prior to the recent turmoil, banks had been tightening their lending standards in anticipation of rising delinquencies and defaults. Consequently, credit growth was already set to roll over. The need now for banks to preserve liquidity, increase funding costs to maintain deposits, and deal with scrutiny by chastened regulators will further reduce their willingness and ability to provide credit to their customers.
Overall financial conditions will therefore tighten as banks dial back lending and shore up their own balance sheets. Bond markets anticipate that this shift in mindset will help cool the economy and do some of the Fed’s inflation-fighting work for it. Short and long-term Treasury yields have dropped sharply as a result.
Similarly, equity markets have rallied, also looking beyond the stresses in the banking sector. Investors have actually been reacting favorably to “bad” news; again, the view being that tighter lending standards will reduce economic activity and lead to meaningfully slower inflation — and without triggering a recession.
Powell’s hydra
Paul Volcker vanquished inflation while years later, Ben Bernanke helped resolve a banking crisis. Already behind the curve in the fight against the inflation demon, Chair Powell now also confronts a threat to the financial system from the banking sector.
On the surface, there is policy tension between battling inflation and the emerging need to preserve financial stability. The former requires restrictive measures while the latter often demands a printing press. By design, the BTFP loan facility should offer the Fed the flexibility to keep hiking rates to address inflation without threatening the banking system — banks will be able to access liquidity to cover deposits regardless of the impact of higher rates on the market value of their investment portfolios.
Powell’s Fed seems in no mood to turn dovish just yet. Policymakers still hiked the fed funds rate by 0.25% in late March — albeit at half the pace expected before the collapse of SVB. Although stubbornly high, inflation appears to be rolling over and the rate hikes should be about done. But this does not imply that policymakers are about to reduce rates and begin easing — as the bond markets expect — absent a recession.
Not so easy
Financial markets have been buoyed by accommodative monetary policy for much of the last 40 years and extremely loose policy for the past 15. When interest rates hover near zero, many investment opportunities will appear attractive, particularly those financed by debt. For instance, consider the commercial real estate boom of the last decade which was propelled in part by very low borrowing costs.
And in a low-rate environment, higher valuations are easier to justify. At times, speculation and froth emerge as risk becomes under appreciated. Questionable investments can proliferate. Suddenly, capital is allocated toward entities such as crypto currencies, Non-Fungible Tokens (“NFTs”), and Special Purpose Acquisition Companies (“SPACs”). That rarely ends well.
Presently, we are now on the other side of a super-easy monetary policy cycle. Although interest rates should decline as inflation is corralled, it is difficult to envision yields reverting back to near zero levels. However, over time, the economy can still prosper and companies with rising profits will continue to be rewarded.
Christopher J. Singleton, CFA, Managing Director
April 19, 2023