Why US banking stress is different this time – 03/21/2023 – Why? Economês in good Portuguese

In the past two weeks, three banks have failed in the United States: Silicon Valley Bank (SVB), Signature Bank and Silvergate Bank. SVB and Signature corresponded, respectively, to the second and third largest bank failures in history.

Other banks such as First Republic and, in Europe, Credit Suisse did not collapse, but experienced severe instability. By the end of last week, banks in the United States, Europe and Japan had collectively lost nearly $500 billion in market value for the month. Efforts by public authorities to quell the panic and stabilize the system were only partially successful.

The question arises: is the US banking system on the brink of a precipice like the one in 2008? Could the last two weeks be the harbinger of a new systemic crisis?

Since last year, three significant changes have taken place in the macroeconomic regime of advanced economies compared to the post-Global Financial Crisis period. First, already in 2021, the possible chronic insufficiency of aggregate demand from the previous decade gave way to supply-side constraint shocks and rising inflation. As a consequence, the era of abundant and cheap liquidity provided by central banks gave way to higher interest rates and the shrinking of their balance sheets in 2022. Finally, as a result of these changes, there was a strong devaluation of financial assets last year and fears about to multiple possibilities of shocks in 2023. Could such shocks underlie the banking stress of the last two weeks?

There are several reasons to differentiate the current situation from that prior to the global financial crisis. First of all, in the wake of the financial crisis and regulatory reforms, including the Dodd-Frank legislation, the US banking system has significantly increased its level of capitalization. Larger banks were required to maintain higher proportions of equity capital and reserves in relation to portfolio assets. Big banks also undergo stress tests every year. Such tests often include checking the impact of large swings in interest rates on your finances.

The system’s liquidity has also increased, as banks are now required to hold enough of their assets that they can be quickly converted into cash to meet net cash outflows in a stressed environment. This liquidity coverage requirement is particularly stringent for banks with more than $250 billion in assets.

On the side of banking assets, also unlike the period before the global financial crisis, there is no picture of general deterioration, as was the case with the nexus with bad real estate assets before 2008-09. The financial system has not been suffering from significant credit problems, as credit quality for businesses and households has generally remained high during the pandemic and other shocks in the recent past. Governments increased their debts and central banks inflated their balance sheets to move money into economies, with the private sector seizing the opportunity to extend debt at low interest rates.

Strictly speaking, a vulnerability on the side of bank assets concerns fixed-income public securities that banks hold in their portfolios at a time when interest rates are rising. If such low-risk bonds can be held to maturity, that’s fine. But a loss appears if before that the banks need to sell them or recognize their market value. This can be called “interest rate mismatch risk” or “carry trade risk”. It is estimated that US banks incurred more than $620 billion in mark-to-market losses last year.

So, one might ask, where did the failures and distrust of banks, particularly regional and community banks in the United States come from? Are recent bank failures signaling more bank runs and bank failures in the works?

Failed institutions were not among those covered by the tight prudential regime. As well as others currently under stress. Legal changes in 2018 made this prudential standard non-mandatory for banks with less than $250 billion in portfolios.

SBV was a medium-sized bank with a strong concentration of assets in the form of fixed-income government bonds and, therefore, vulnerable to the aforementioned “mismatch risk”. In addition, nearly all of its depositors had deposits well above the insurance limit given by the Federal Deposit Insurance Corporation (FDIC), which is up to $250,000. Thus, it is understood the speed of flight of depositors and the sudden fall after the recognition of losses with fixed income securities to be sold by the bank.

The response from the authorities in the United States on Sunday after the SBV crash was significant, both in terms of the extension of deposit insurance –without saving shareholders and creditors– and the one-year credit line created to help other banks hold government bonds in their portfolios. and avoid the repetition of what happened with SBV. Some even call this a new “quantitative easing” in parallel with the ongoing “quantitative tightening”.

To see if the transfer of deposits from these regional and community banks to large banks or money market funds will cool down. It can be said that the banking stress so far has not been a harbinger of collapse, but the change in the macroeconomic regime will bring new shocks. Attention should also be paid to non-bank financial institutions that have partly replaced bank intermediation since the global financial crisis.

In Europe, the banking problem was reasonably limited to the Swiss bank Credit Suisse, whose saga until its acquisition by UBS reported on Sunday had already unfolded for some time, being aggravated by events on the other side of the Atlantic. That’s why European Central Bank President Christine Lagarde, when she announced a 50 basis point rise in interest rates last week, could afford to note the absence of weaknesses in the eurozone like those on the US side. She could even say that the objectives regarding inflation and financial stability there are the object of different instruments.

Sunday also saw the announcement of an agreement between the Federal Reserve (Fed), the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Canada and the Bank of Japan to switch to dailies, since yesterday, the weekly auctions of dollars. Daily swap lines are expected to run at least through the end of April in an effort to “ease tensions in global funding markets”.

Returning to the United States, it can be said that the Fed’s dilemma between fighting inflation and ensuring financial stability has become tighter, with “financial dominance” if interest rates are kept below what the policy against inflation would recommend. Despite optimism that the stress on the financial system will be contained, a tightening of financial conditions – in equities and credit – is already taking place.

Strictly speaking, it is too early to say that other market fears and the disappearance of liquidity for other banks are behind us. Yesterday, for example, liquidity had not yet returned to First Republic Bank and its shares collapsed. There is a clamor to extend what has been done with the SVB in terms of deposit insurance coverage.

At the meeting of the Fed’s Monetary Policy Committee taking place today and tomorrow, one can rule out the 50 basis point hike that chairman Jerome Powell hinted would be the case on the Tuesday that preceded the SVB bankruptcy. However, between taking time to see, keeping interest rates where they are, and raising them by just 25 basis points, I bet the option will be the second one.

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