Strategy blog: Banking stress containable
Risk-off prevailed in global capital markets towards the end of last week as concerns over the health of the US bank system moved into focus, following the collapse of Silicon Valley Bank (SVB). The bank suffered from a combination of idiosyncratic headwinds – high deposit withdrawal rates, a slowdown in funding and a concentrated (venture capital) customer base – compounded by losses on its treasury and mortgage-backed security portfolio. Its large investment portfolio was particularly exposed to longer-dated bonds, with little hedging to protect against rising policy rates.
We are, of course, watching the situation very closely for signs of contagion, which could threaten a wider contraction in credit and liquidity.
Policymakers have been quick to act. The US Treasury, Federal Reserve (Fed) and FDIC announced that they would fully protect all depositors with SVB – even those that were uninsured (but there are no plans for a wider bailout of shareholders and bondholders).
Moreover, the Fed announced that it would provide liquidity on demand to 'eligible depository institutions': the creation of a new Bank Term Funding Program (BTFP) offers loans of up to one year in length, with Treasuries/mortgage-backed securities as collateral. Importantly, the collateral will be valued at par, rather than mark-to-market, inflating the value of those assets relative to market value.
Of course, some contagion is inevitable. The highly-exposed Signature Bank – a key intermediary in the crypto space – has also closed (though regulators have protected customers' deposits there as well), while First Republic's shares have continued to sink today.
Unsurprisingly, a flight to safety has prompted a rally in bond markets and market-implied policy rates have also shifted sharply lower: the latest pricing suggests that the Fed funds rate is no longer expected to exceed 5%, a reduction of roughly 1 percentage point. Financial stability – alongside price stability and full employment – remains one of the Fed's central tenets, the lender of last resort. While we don't yet think the Fed is likely to reverse policy rates, it would be contradictory to continue tightening policy rates on the one hand, while easing liquidity conditions on the other.
From a fundamental standpoint, major banks' balance sheets are far stronger and more liquid than they were during the last big financial crisis, and authorities have been quicker to react (SVB is not as systemically important as Lehman either). Bank stocks have been hit hard, but interbank spreads and major banks' credit default swaps have risen only modestly as yet.
Given the nature of the risk – and still-fresh memories of the Global Financial Crisis – further market nervousness and volatility is likely, but the injections of liquidity needed to put out this fire may not be that large, or have major economic consequences.
From a top-down perspective, we have been waiting for residual cyclical risk to be dispelled: that risk has now been refocused on earnings rather than interest rates, but it leaves us still waiting for clarity. However, we do not think an outright reduction in risk assets from current levels is appropriate.
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