In the words of the great Yogi Berra, the shenanigans in global banking over the past two weeks are “like déjà vu all over again.” The failures of Silicon Valley Bank and Signature Bank in the US and the forced merger of Credit Suisse with UBS have given rise to fears of another bank-induced shock to the global system along the lines of 2008. My own view, for what it is worth, is that we are not on the cusp of a similar shock. But this does not mean that we will escape unscathed and there are lots of questions surrounding the current state of the banking landscape which will continue to reverberate and which may yet have far-reaching implications.
Balance sheet issues
The good news is that systemically important banks are
adequately capitalised, at least according to the requirements laid down in the
Basel III legislation implemented in the wake of the GFC (see table below). But as with all past
crises, the introduction of new regulations is a response to the last war.
Rising rates are the biggest problem
The reasons why banks are once again front and centre of the market debate are complex. But in large part the issues can be traced back to the sharp global monetary tightening that we have seen over the past year. Central banks have raised rates in response to inflation without really having a good understanding of how the monetary transmission process works. Indeed, so far any declines in inflation are due only to the impact of big oil price spikes dropping out of the calculations – nothing to do with tighter monetary policy – and there are real concerns that a sharp tightening of monetary policy will throw the European and US economies into recession. The pace of tightening in the US is the fastest since the late-1970s with the Fed funds rate having risen by 475bps in 13 months (an average of 0.36bps per month). The last time policy was tightened so aggressively was in 1978-79 and the result was recession.
Although in theory rising interest rates are good news for a banking sector that borrows short and lends long, higher rates also have adverse consequences. Aside from the fact that US banks are sitting on a bond portfolio whose market value is worth considerably less than they paid for it, there are mounting concerns about banks’ portfolio of commercial property. The dual impact of an economic slowdown and higher rates take the edge off property prices, reducing the value of the collateral against which loans are secured. Banks will be less willing to lend in these circumstances, potentially triggering further weakness in the commercial market. The fact that this sits on the balance sheet of regional US banks, which account for 70% of all commercial property lending, further amplifies the risks posed by the asset position of the US banking sector.
An additional problem is that banks have suffered from deposit outflows over the past year (chart above). The reason is that deposit rates tend to rise more slowly than lending rates with the result that depositors have an incentive to seek higher yielding alternatives, which goes a long way towards explaining why there has been a big inflow into US money market funds in recent weeks. According to Refinitiv Lipper data, US money market funds received a net $59.3bn of inflows in the week to March 29 bringing the monthly total to $273.3bn versus bank deposit outflows of $187bn over the first half of March.
Implications
The conditions which triggered the Lehman’s crisis of 2008 are not present today. Central banks have adhered to the Bagehot doctrine of providing ample liquidity against good collateral (whether they have done so at a penalty rate is moot). Although markets were spooked by the Credit Suisse issue and market concerns about Deutsche Bank were prevalent a week ago, if there are problems in the global banking system, they are more likely to emerge in the US than Europe.
By fully guaranteeing SVB depositors, despite the fact that many of them had deposits in excess of the $250k limit, the US authorities have sent a signal that there is no need for a rush to the exit which ought to limit the prospect of further bank runs. But whilst the kind of explosive shock which resulted from the Lehman’s bust is unlikely, there is still the prospect of a more slow-burn problem.
In some ways, the recent problems are reminiscent of the Savings and Loan crisis of the late-1980s/early-1990s. S&Ls were subject to limits on the interest rates they could offer to depositors, which consequently led to a major outflow of deposits to money market funds. Deregulation in the early 1980s encouraged them make risky loans in a bid to generate attractive returns, which went sour as the Fed tightened policy. S&Ls were encouraged to act in this way by taxpayer-funded guarantees provided by the Federal Savings and Loan Insurance Corporation which created an enormous moral hazard problem. Between 1986 and 1995 almost one-third of S&L institutions ceased to exist and although it was a slow burner, the demise of S&Ls was a contributory factor to the US recession of 1990-91.
This is not to say that history will necessarily repeat itself but it should act as a warning signal for central bankers who continue to believe that excess inflation is the main problem for them to worry about. Rapid monetary tightening will exacerbate weaknesses in the financial system and a prudent central banker might wish to hold fire on further rate hikes, especially given the magnitude of the tightening put in place over the last year.
[1] Diamond D. and P. Dybvig (1983) ‘Bank runs, deposit insurance, and liquidity’, Journal of Political Economy, 91 (3), pp401–419
