The collapse of Silicon Valley Bank and Signature Bank heightens the Federal Reserve's policy dilemma over fighting inflation while maintaining financial stability. We analyze what the crisis means for the banking system and the economy.
- High interest rates have hurt the mark-to-market value of high-quality bank assets like Treasuries.
- The guarantees to depositors are intended to stem emotional behavior that threatens bank liquidity.
- With banking reserves and credit creation under pressure, the probability of recession increases.
Days after the event, debates continue in the Twitterverse and other forums about the good vs. evil of the perceived "bailout" of Silicon Valley Bank (SVB) and Signature Bank by the FDIC over the past weekend. While there were certainly idiosyncratic issues with respect to SVB, the FDIC, in concert with the Fed and Treasury, invoked a systemic risk exception to guarantee all deposits in both banks. The intention of this action was to prevent bank runs from spreading to other institutions, particularly in an age of instant digital payments and the ability to move cash with one or two clicks of a button on your phone, and an age when rumors spread rapidly via social media.
What is money?
These events pose important questions for the financial system. What is "money"? Is it only physical U.S. dollars that are "legal tender for all debts, public and private"? When you park cash in a savings or checking account, is that "money"? These questions strike at the heart of our fractional reserve banking system. At a high level, the business of, and accounting for, a bank is straightforward. Banks take deposits, which then become liabilities to the bank, and then, on the asset side of the ledger, banks either make loans or hold securities. These days, in the post-GFC world, those securities tend to be very high quality — often agency mortgages or Treasuries, which carry the explicit guarantee of the "full faith and credit" of the U.S. government (which, incidentally, also owns the printing press used to create those U.S. dollars).
Liquidity at risk, not solvency
The mark-to-market value of many of these bonds/assets have taken a hit over the past several months as interest rates have risen, but again, these bonds will mature at par if held to maturity. The resulting issue of many depositors demanding their cash back at the same time thus creates a liquidity issue, but not a solvency issue.1 These timing issues are an inconvenient truth in the way our banking system is structured.
Not a bailout this time
The actions taken to protect the depositors of SVB and Signature Bank were not a bailout: Both institutions have failed, and the equity holders and most creditors will be wiped out. Until this past weekend, a single dollar of deposits in any bank over and above the FDIC's $250,000 insurance limit were technically an unsecured liability of the bank. But it would be an incredibly inefficient system if every depositor (individuals and companies) were to be required to open accounts at multiple banks if they happen to let their cash levels run above the limit at any given point in time. As one member of Congress recently shared with us, wealth does not equal financial sophistication.
The risk to Credit Suisse
The guarantee of all deposits is meant to stifle the emotional urge for a mad scramble to find the next vulnerable bank, ad infinitum — thus, the deemed "systemic risk." If left unchecked, this behavior, followed to its logical conclusion, could leave us with just one "safe" bank in the end. And, of course, there are global ramifications as well, with the long-simmering issues surrounding Credit Suisse seemingly coming to a final crescendo, showing many of the same behavioral dynamics at play. Credit Suisse is more worrying because of its inclusion as one of the supranational Financial Stability Board's 30 largest G-SIBs (global systemically important banks). Given the plumbing of the global payments system and interconnectedness of global counterparty credit risk concerns, Credit Suisse has now received a backstop from the Swiss National Bank in hopes of stemming any risk of global contagion. We continue to actively monitor high-frequency indicators of ongoing stress in funding markets (see Figure 1).
Figure 1. New signs of banking system stress
Discount window borrowing and FRA-OIS spreads
Sources: Bloomberg and New York Federal Reserve. FRA-OIS measures the difference between three-month forward U.S. rate agreements and the rates on overnight index swaps.
What the Fed is likely to do
Of course, this all puts the Fed in a tricky spot, as it needs to consider its roles as both macroprudential supervisor and monetary authority, the latter requiring it by charter to seek maximum employment and price stability. The events of the past week put these two roles somewhat in conflict with one another. Fed Chair Powell has been at pains to reinforce during this rate-tightening cycle that the Fed is out of the forward guidance game — that they are "data dependent." It is therefore no small bit of irony that the most recent data on the labor market was delivered simultaneously with SVB failing. And notwithstanding the slight uptick in the unemployment rate (due to an increase in labor force participation), the Fed is still essentially a "one mandate" central bank at this point, with inflation being their overriding concern given the economy is at full employment. They are seeking to avoid the mistakes made in the late 60s and early 70s that ultimately led to the Great Inflation.
We therefore expect the Fed will increase the upper limit of the federal funds target rate another 25 bps in March, while seeking to reinforce the message that financial system stability is best addressed with regulation and not monetary policy. That is, of course, contingent upon these various liquidity guarantees being successful in capping what is essentially an emotional reaction to system stress. The ECB has provided a bit of cover for the Fed to hike again with their decision to increase the European policy rate by another 50 bps as planned, although the vote was not unanimous.
More bond market signals point to recession
The impact of all of this on markets has been most profound in the bond market. Measures of interest-rate volatility have now surpassed levels last seen in the GFC. As far back as May 2022, the Fed was already highlighting concerns about decreased liquidity in Treasury futures, which is by all accounts meant to be one of the deepest and most liquid markets on the planet. That liquidity certainly will have deteriorated now, and while QT (quantitative tightening) has been running quietly in the background, the market is clearly sending a message about necessary levels of reserves in the banking system.
We would also note that the impetus for credit creation in the economy has been waning for some time now, with a constrained IPO market and low issuance in high-yield bonds. The message from the Fed's most recent Senior Loan Officer Survey, released in early February, shows a large tightening of lending standards to all types of borrowers as well as lower demand for credit trends that recent events will only exacerbate. Historically, tightening of lending standards of this magnitude has been a good leading indicator of recession. The shape of the yield curve has echoed that message. Given the rapid growth in private asset markets over the past decade and the disintermediation of the credit creation process into the shadow banking system via private equity and private credit firms, this story likely does not end with the events of the week. There is more to come. We observed in our Q4 2022 Capital Markets Outlook that the Fed was set to tighten, risking recession if something in the economy were to break, and we certainly can say we have now seen that threshold met.
1 Douglas W. Diamond and Philip H. Dybvig, "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy," 1983, vol. 91, no. 3.
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