For those of us who managed money through the financial crisis 15 years ago the events of the last few days seem eerily familiar. Bank bailouts, collapsing bank share prices and the US president telling us our “banking system remains resilient”.
On Sunday, US regulators shuttered Signature Bank based in New York, two days after seizing control of Silicon Valley Bank (SVB). Together, they are the 2nd and 3rd largest bank failures in US history. The details of these banks and their demise are important.
SVB was the 16th largest bank in the US. Founded in 1983 to focus on the needs of start-up companies, it aggressively shifted into being the bank of choice for tech companies in California, more than tripling its deposit base between the end of 2019 and Q1 2022 as cash-flush companies and venture capital funds (VCs) sat on cash they had raised. The core underlying model of a bank is to “borrow short (deposit holders) and lend long (fixed income assets)”. The difference between the two, the net interest margin, is a core driver of a bank’s profits.
For SVB, this worked well as their deposit base grew and interest rates remained low and stable. However, as rates increased and their deposit base declined, they were forced into liquidating assets, incurring significant losses. This process happened gradually through 2022 until a classic loss of confidence and resultant run on the bank forced regulators to step in to protect deposit holders.
A similar fate followed for Signature Bank. While not as large as SVB it has a long history in commercial banking in the US with 40 branches across five states. Like SVB, Signature Bank counted many crypto businesses as clients, with $16.5 billion in deposits from these customers. On Friday, Signature Bank suffered a run on deposits, with more than $10 billion being withdrawn, and the government was forced to step in to protect remaining deposit holders.
In some ways, both SVB and Signature are unique and extreme events. Both had ventured into areas that were very sensitive to the crypto and tech VC bubbles created by zero rates and free money.
The reality is that up until a week ago most investors knew nothing about SVB or Signature Bank, yet in the space of three days we’ve seen a significant re-pricing across major global asset classes as a result of developments at these two banks.
US bank stocks are down 18%, giving back all of their 2023 gains. The same goes for European bank equity, where we’ve seen a decline of more than 13%. On Monday, Moody’s placed six US banks on review for downgrade, stating: “If it (First Republic) were to face higher-than-anticipated deposit outflows and liquidity backstops proved insufficient, the bank could need to sell assets, thus crystalising unrealised losses”.
However, the biggest impact has been in the re-pricing of interest rates, where two-year yields on US bonds have dropped over 100bp from their highs of over 5% a week ago. The market now expects the Fed to do an about-turn in rate hikes when they meet next week. Expectations have now moved to a cut in interest rates later in the year. Once again, it’s the Fed to the rescue!
And therein is the quandary.
The reality is that all developed market central banks remain highly constrained due to inflation and tight labour markets. CPI, at 6% in the US, is still well above target, and the employment rate is at a historic low. While both factors are lagging indicators, this severely restricts the ability of the US Federal Reserve to loosen monetary policy and pump liquidity into the system. That’s been the playbook for 15 years but, now, for the first time in decades, they are severely constrained.
We cannot underestimate how significant this paradigm shift is.
Interest rates have been resetting lower and lower for four decades. Since 2008, the Fed has reset their funding rate to banks from 5% to below 1%. The same is true for central banks in Japan, Europe and the UK. In some of these economies the interest rate was actually set at a negative rate. What is more important is how long rates remained at zero. It effectively re-priced every asset on the planet. It allowed all borrowers to reset their funding costs lower and lower. In that it changed business models, enabled financial engineering to leverage returns (think private equity) and, most importantly, it severely curtailed sensible risk management. Why invest in something that guarantees a negative real return when you can double your money in a week with a punt on crypto or Tesla?
And now, in the space of 12 months, they’ve completely reversed course and implemented the fastest tightening in monetary policy since Paul Volker’s Fed did more than 40 years ago.
How can we expect things not to break?
Up until last week, the 2023 market consensus view had been built on a soft-landing for the global economy and an orderly adjustment to a world of higher interest rates with business and financial models re-calibrated to a new paradigm.
History tells us that’s unlikely.
What’s more likely is what SVB and Signature Bank are telling us. Excess liquidity fuels risk-taking and credit creation. What goes up must come down. So, an extreme reversal in liquidity ultimately leads to the next leg in this bear market – a credit default cycle and a contraction in the global economy.
How severe that downtown will be is largely due to confidence. The events at SVB and Signature Bank remind us of how fickle that confidence can be.
Anton Eser discussed this topic with Michael Avery on the 16 March episode of Not The Daily News on Classic Business. You can listen to the episode here:
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