This time was not different: the Fed hiked until something broke

Summary:

Silicon Valley Bank was the second-largest default of a US bank in modern history. In our view, there is no threat to the overall banking system, but the dynamics will remain negative for smaller US financial institutions.

Silicon Valley Bank (SVB), the 16th largest bank in the United States (US) with c. USD 208bn in assets was taken over by the Federal Deposit Insurance Corporation (FDIC), an independent agency created by Congress to maintain stability and public confidence in the financial system. The demise of SVB is a tale of poor risk management by the bank’s treasurer alongside the monetary policy whiplash by the Federal Reserve (Fed). The bank’s assets doubled in 2021 when venture capitalists were awash with liquidity, fruit of the partial reopening of the economy (while the service sector was shutdown) and helicopter money promoted by the US Treasury and the Fed. The management of the bank opted to invest most of the windfall deposits in fixed rated instruments which were considered safe, such as mortgage-backed securities (MBS) and classify them as hold-to-maturity (HTM) assets on its balance sheet.

Since last year, SVB had been suffering deposit redemptions because of a collapse in cash available in the tech and venture capital systems. At the same time, the Fed was hiking policy rates by 425 basis points (bps) after having provided forward guidance for only 75bps of hikes, leading to severe losses in the disposal of the long-dated instruments.

On Sunday, Signature Bank (SB) also collapsed due to similar problems, after which the Fed, US Treasury and FDIC released a join statement where they pledged to give access to 100% of non-secured deposits from both banks, while shareholders and certain unsecured bondholders (presumably holding company bonds) would not be protected.1 The statement said there would be no loss borne by the US taxpayer, as any losses to the FDIC would be covered by a tax levied on banks.2 In a separate press release, the Fed created a credit line called Bank Term Funding Program (BTFP) offering loans of up to one year at the Secured Overnight Financing Rate (SOFR) +10bps against collateral in the form of US Treasuries (UST), agency debt and MBS at par. Providing cheap funding at par allows banks to monetise their HTM assets instead of selling them at a loss. The Treasury is providing USD 25bn from the Exchange Stabilisation Fund as a backstop for the BTFP.

Thus, regulators can claim they are avoiding a moral hazard while backstopping a massive run on bank deposits that could turn the failure of some small, poorly run banks into a systemic risk. However, this is not cost-free. First, large banks may have to pay the cost of the depositor bailouts. In the case of SVB, the cost will be small. SVB has a simple balance sheet that does not seem to be overly leveraged. Notwithstanding the likelihood of wiping out equity and subordinated debt holders, there is a moral hazard element in the bailing out of depositors: In a functioning banking system, banks should compete for deposits and all stakeholders should be on the line in case of mismanagement. The consequence is that regulations for the sector will tighten, increasing the risk of overregulation and the stiffening of conditions for the good players. But this is a price worth paying to avoid a bank run.

For completeness, this does not represent the return of quantitative easing (QE). Sure, the balance sheet of the Fed may expand, but will do so in a way that the banking system is forced to de-risk, while in QE the system has an incentive to increase risk taking. When a central bank carries out QE, it buys a security from a bank, which is now left with riskless reserve assets and will seek to replace that with either a similar or riskier security.

Thus, in the classic QE flow, adding fresh money into risk assets leads to lower risk premium. If BTFP becomes operational, is because depositors will be withdrawing funds from banks to invest in (higher yielding and saver) money market funds and banks will be using their assets as collateral to a loan from the Fed to repay the depositors. This will force the bank to de-risk its balance sheet, disincentivising risk taking. Counterintuitively, this process may lead to a steepening of the curve, but a bear steepening as the de-risk increases the chance of a sharper economic slowdown, which puts downward pressure on the front end of the curve.

Despite the good deed of the actions, alas we don’t believe the banking system is out of the woods with the bailouts of SVB and SB. Bank collapses, even if well managed, tends to leave a scar in the country’s financial system, and this is the second-largest bank collapse in recent history (behind Washington Mutual in 2008).

The trauma was related to several high-profile failures in the cryptocurrency space, including a high-profile fraud in one of the largest crypto brokers – FTX. Beyond the crypto and venture capital community, social media will propagate the dramas played out by the bank failure, just as digital banking makes moving resources much more convenient. Hence, unless the Fed decides to U-turn again and open the liquidity spigots (unlikely in the short-term considering current inflation levels) the problems in the system will persist.

Despite the implicit protection of depositors, the volume of deposits in the system is much larger than the guarantees currently provided. There is USD 5.46trn of securities (23.9% of bank assets), of which USD 1.38trn is held by small banks (20.4% of small bank assets). Against that, the Fed capitalised the Exchange Stabilisation Fund (ESF) with USD 25bn. Even if you lever the ESF by 10x, the volume sounds small compared to the system’s needs. And the fact that non-depositor liabilities are not guaranteed keeps all creditors to the banks nervous. Why would anyone keep their assets in a small bank in this environment? If investors redeem their assets to invest in (higher yielding and safer) money market funds or in global systemically important banks (G-SIB), the small banks will be forced to de-risk their balance-sheets as they borrow money from the BTFP.

The big risk in the balance sheet of these banks is not poorly run banks getting too much exposure to in HTM, MBS and UST below par (now addressed by Fed bailout), but commercial real estate. Small banks hold 30% of their assets in commercial real estate, as per Figure 1, a much larger concentration than large financial institutions.

Furthermore, small banks have already lost 51% of their cash, or USD 463bn its peak while large banks lost 39% (USD 812bn) which forced them to lower their cash position from 14.1% of total assets to 6.5%, while large US banks still have 9.8% of its total assets in cash (down from 16.6%) and as per Figures 2 and 3. This time was not different: the Fed hiked until something broke_1

This time was not different: the Fed hiked until something broke_1

This time was not different: the Fed hiked until something broke_2

This time was not different: the Fed hiked until something broke_3

Nevertheless, the backstop mechanism is welcome, particularly if its size can be called up, as several other banks (including large ones) have similar problems in their balance sheet from the fast increase in interest rates as the system has approximately USD 600bn of losses in HTM and available-for-sale securities.

Furthermore, this crisis should not pose a systemic threat, in our view. US banks have never had more liquidity than today, making a systemic crisis in the G-SIBs like 2008 hard to fathom. US banks held 32.3% of all their assets in cash, US Treasuries and agency bonds, the largest concentration since the inception of the series starting in 1972 aside from 2022, against only 13.5% in December 2007. This time was not different: the Fed hiked until something broke_4

This time was not different: the Fed hiked until something broke_4

In conclusion, the insolvency of SVB presents a financial stability risk – to the extent that it increases the risk of a run on the deposits of small financial institutions, which have already lost a significant portion of balance sheet cash and have a larger share of commercial property in their assets – but not a G-SIB risk. The underlying reason that brought the SVB into insolvency should be relatively easy to be addressed by the Fed, in our opinion.

In macro terms, the Fed will have to provide liquidity against collateral, which is not QE. However, it will be very hard for the Fed to justify quantitative tightening and hiking policy rates in an environment where it must also provide ample liquidity to backstop the banking system. In our view, it would be hard to justify hiking rates (perhaps even by 25bps) as was priced by markets at the close last Friday. The yields on two-year US Treasuries collapsed 86bps in two trading sessions, and are now trading below 4.20% as the spread between the two-year and 10-year US Treasuries surged 43bps (now at -0.95%). The yield curve always steepens ahead of recession.

Interestingly, the dollar index is down 1.5% in the same period of a US Treasuries sell-off. So, the classic ‘Dollar smile’ model when the USD outperforms when the US economy outperforms, but also in a recession, is slowly breaking down. Fundamentally, we may see the Dollar weakening further, since foreign investors hold 58% higher exposure in US equities (USD 11.5bn), than to US Treasuries (USD 7.3bn) and US capital market underperformance may lead to further outflows from US stocks.

Source：Ashmore

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This time was not different: the Fed hiked until something broke

Source：Ashmore

Risk Disclosure