Last week the panic was about California based Silicon Valley Bank (SVB). On Friday, SVB was closed with the Federal Deposit Insurance Corporation (FDIC) named as its Receiver. Over the weekend the contagion spread to New York based Signature Bank. It was widely reported that 90% of deposits held at SVB were not insured, because the amounts held, whether by people or firms, exceeded the $250k threshold under which the authorities would guarantee safeguarding deposits in full. At Signature Bank it was reported that 93% of deposits exceeded the guaranteed threshold.
Across the US, of the over $18 trillion of deposits held, around $10 trillion are captured under the $250k guarantee. Thus, a lot of funds were not guaranteed.
A swift policy response
By the weekend, the risk of bank-runs would have been a genuine fear for the US authorities. A repeat of what was seen at the end of last week – with a rush to withdraw deposits at SVB – could have been experienced across the US. Now, as a result of the policy actions announced over the weekend, one would expect deposit flight, from smaller to larger banks, to be halted, or at the very least slowed.
On top of this, about $5.5 trillion of deposits are parked in regional banks. SVB had not effectively managed its interest rate risk, having seen an influx of deposits during the pandemic. This has triggered a wider concern about whether interest rate risk has been managed properly across other banks, in an environment where policy rates and bond yields have risen. Thus, despite the bailout announced over the weekend, the share prices of many smaller or regional US banks have suffered.
In this environment, the US authorities have taken action to limit contagion – across the banking and financial sector and wider economy and to shore-up confidence among depositors and investors in banks. There was a Joint Statement by the Department of the Treasury, Federal Reserve and FDIC on Sunday evening which outlined the action being taken to address the problem at SVB and limit contagion. Notably it stated that, “Depositors will have access to all of their money starting Monday, March 13.”
At the same time the Fed announced a ‘Bank Term Funding Program’ (BTFP) with a significant US Treasury backstop: “…the Department of the Treasury will make available up to $25 billion from the Exchange Stabilization Fund as a backstop for the BTFP. The Federal Reserve does not anticipate that it will be necessary to draw on these backstop funds.”
Limiting contagion
The US reaction is aimed at limiting bank runs and protecting depositors. It does not help the shareholders or bondholders of the banks impacted. That latter factor might lead some to regard this as a bail-in, not a bailout.
While some might think that addresses the moral hazard problem it doesn’t, given the risk management problem that has been highlighted here – the relationship between assets and liabilities was one of the core issues with SVB. Because of the nature of the policy response, banks who were exposed by higher rates and did not manage their interest rate risk will be treated the same as others who did and who might have been more conservative in their approach.
That is because another significant policy change announced Sunday was that collateral would now be valued at par, and not at market prices, or indeed at a fraction of market prices as is often the case in bailouts or financial crises.
This is important in the context of the Fed now allowing US banks access to the discount window for one year, not 90 days as was the case. Who is to say this will not be extended, if needed? It allows significant near-term support to limit contagion across the banking sector.
Effectively, this acknowledges that higher policy rates will have forced bond prices sharply lower, impacting some banks, as we saw with SVB. Importantly the increased facility reflects the high quality of the collateral held as assets and makes allowance for any funding mismatch as a result of their long maturity. This action by the Fed should allow banks time to adjust to a higher rate and higher yield environment.
The latter is not just important now, but a wider issue is what constitutes a ‘risk-free asset’. In an environment of high public debt and deficits to be funded, the last thing the US – or indeed other – authorities could afford is a reassessment of the safe-haven nature of government bonds.
The UK approach
Meanwhile, in the UK, a private sector approach was adopted to limit any fallout from the latest events. The nature of banking in the UK is very different. The number of banks is far smaller, they are well capitalised and have rigorous risk management. The authorities – HM Treasury and Bank of England supported by the regulators – brokered a very effective outcome.
HSBC acquired SVB’s UK business for £1. It is reported that it had £5.5 billion of loans and £6.7 billion of deposits, with a pre-tax profit of £88 million last year. This action was aimed at limiting contagion, not just across the financial sector, but also to the reported 3,000 tech firms with deposits at the UK business of SVB.
Of course, the UK experienced a problem last autumn in terms of liability driven investments (LDI) – and while the specifics of these were caught out in the aftermath of the mini-Budget, it was indicative of the wider problem we are seeing now as higher policy rates has led bond yields to rise. The worries about inflation at the time and the speed and scale of increasing market rate moves exacerbated that problem.
The backdrop: the end of cheap money
The backdrop for all of this – whether in the US, UK or euro area – is, of course, the end of cheap money. As a result, the latest developments will impact market thinking about future policy tightening – particularly in the US. Last week, in the wake of Fed Chair Powell’s comments, the market had priced in the risk of more aggressive tightening by the Fed.
Now, in the wake of this crisis, the market has revised down its thinking. In the US two-year yields, for instance, were just over 5% after Powell’s comments early last week. Now, these are around 4.20%. The market is worried that the economy will suffer, with future tighter lending conditions arising from this crisis. It is not just policy rates, but the scale and speed of asset sales by the Fed, their equivalent of quantitative tightening, that may need to be reassessed.
From 2008 until the start of last year, the backdrop for financial markets and western economies was cheap money. The initial monetary policy response in the wake of the global financial crisis (GFC) was welcome. Alongside the fiscal easing – outlined in the 2009 G20 London Summit – that pulled the global economy back from the brink. However, cheap money continued when it shouldn’t have, through the subsequent decade and more.
As we have noted numerous times, cheap money led to many problems including: asset price inflation; contributing to the environment in which inflation has taken off in recent years; prompting markets to not price for risk; and leading to a misallocation of capital. Some firms, as we are now perhaps seeing, did not manage their risk properly – perhaps expecting cheap money to continue.
Central banks – including the Fed and the BOE – also misread the shock from the pandemic, interpretating it as similar to the GFC shock. However, the GFC shock was a demand side one, the pandemic a supply-side one which exacerbated the inflation outlook. Thus, the rate cuts and subsequent quantitative easing was inappropriate.
Over the last year, we have seen significant monetary tightening. The scale and short timespan over which this tightening has taken place, in the US in particular but also in the UK, has led us to feel that the authorities needed to tread carefully. The tightening that has already taken place over the last year will take time to feed through fully. Monetary growth and lending has already slowed significantly, particularly in the US, while the full financial implications are still feeding through, as we have seen with these latest developments.
Of course, while inflation is decelerating, core inflation may prove stubborn and thus it is unclear where headline inflation will settle even though it may undershoot over the next year. Terminal policy rates may still need to be higher, but the latest events will likely lead central banks to reassess their policy stances. We have felt that the Fed and BOE should pause. These events fit with that thinking, but let’s see how they respond.
It would be a surprise if the latest developments do not impact the Fed’s thinking. It’s not just the direct impact but the indirect consequences of events and how the fallout from SVB impacts wider confidence and behaviour. There is no easy way to move away from an end of cheap money. But the pace and scale of policy rate hikes and asset sales by the central bank needs to be mindful of both the economic and financial impact of that tightening.
Please note, the value of your investments can go down as well as up.
