The Big Idea
Surveying the wreckage
Stephen Stanley | March 17, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
It is premature to draw firm conclusions about the fallout from the banking turmoil of the past two weeks. But we can make preliminary assessments. Financial conditions are likely to tighten at the margin, but this is exactly what the Fed has been trying to accomplish. It would take a substantial snugging in lending standards and other financial parameters to alter the economic and monetary policy outlook, a prospect that, for now, appears unlikely.
A run on banks, not the banking system
Each of the banks that failed over the last two weeks, Silvergate, SVB and Signature, had idiosyncratic businesses that subjected them to particular vulnerabilities. Silvergate and Signature catered to the crypto sector. In fact, Barney Frank, who was on the board of Signature, claims the bank was solvent but was taken over by New York state regulators because of their crypto emphasis.
SVB’s issues have been well documented. The bank’s customer base focused on tech startups enjoyed an epic accumulation of funding, a result of the Fed’s exceptionally—and in retrospect, excessively—easy monetary policy. This led SVB’s deposits to more than double in a short period. SVB could not possibly lend out the bulk of that deposit growth, which led them to heavily buy securities. Their bond holdings fell sharply in value once the Fed began to rapidly hike rates. When SVB sold securities to bolster liquidity, it was unable to raise capital to offset the loss it took. Nervous customers pulled their deposits, and the bank shockingly unraveled.
The key point here is not so much the details of the banks’ failures but the fact that each had a unique story. Unlike 2008, there has been little or no concern about the banking system. In fact, from a macro perspective, the bank run has been a zero-sum game as nervous depositors move their cash from smaller banks perceived as risky to larger banks. When the dust settles, bank deposits in total will be largely unchanged. Regulators may not want to see further concentration in the banking system, with money center banks sucking in more and more of the deposit market. But it is important to note that in the short run, from the perspective of the financial system as a whole, these flows should net out.
There is one other element of the current financial system worth mentioning. The banking system as a whole has been sitting on massive amounts of excess liquidity, a function of the Fed’s gargantuan balance sheet expansion in 2020 to early 2022. In fact, while specific banks (like SVB) might have been fighting hard for deposits, the system as a whole has been happy to see deposits run off over time.
This is why the largest banks, who have seen a massive infusion of deposits in the flight to quality of bank depositors, are in a position to deposit billions of deposits into First Republic, a step that underpinned the bank that many felt would be the next domino to fall. In 2008, the entire banking system was under stress, so that the federal government had to step in and support everyone through TARP loans. This time around, the large banks were able to redeploy their flight-to-quality inflows to a vulnerable regional bank, essentially reversing a portion of the moves taken by individual and business accounts.
If this assessment of the banking system is correct, then the events of the past 10 days do not have to necessarily result in a change to the economic outlook. Still, there are three different paths for recent turmoil to hinder economic growth.
First, the banks receiving deposits may have different lending behavior than the ones losing deposits or failing. As an example, tech startup firms may find it more difficult to get the same terms that they were receiving from SVB at a money center bank. Financial conditions, especially for those specially targeted by the banks that have come under stress, consequently could tighten somewhat. Still, I suspect that this factor will be quite small in the context of the overall economy.
Second, the turmoil could lead a wide array of banks to take a more conservative approach to lending. In my view, this represents the most likely path to a substantial change in financial conditions that lasts beyond the immediate market upheaval. It stands to reason that, even if the current turmoil calms soon, banks that were in the firing line this week may choose to rein in the risk that they are willing to take on both sides of the balance sheet.
I would not be surprised to see this dynamic play out to a degree. However, there have been few if any issues throughout this episode with banks’ loan portfolios. Instead, the problems have arisen from unrealized losses in banks’ securities portfolios as well as the reality that deposits are more easily lost than previously assumed. While a tightening in lending standards would be understandable, it is not necessarily inevitable.
Finally, a sustained period of financial market turmoil could also reverberate back to the real economy. For example, spreads for ABS spiked over the past week along with a range of other indications of financial market risk, which led to the postponement of a number of deal pricings. In the extreme, if the deal pipeline locks up for an extended period of time, it could lead to less favorable lending standards for loans. This happened in 2008. However, if the crisis mentality fades over the next few weeks, this avenue is unlikely to lead to a persistent drag on the economy.
It is also important to keep in mind that the Fed has for some time been trying to tighten financial conditions and struggling to do so. Monetary policy stayed too easy for too long in the aftermath of the pandemic, leading to excesses in the financial system that helped to overheat the economy. Indeed, panning further back, monetary policy has arguably been easy non-stop since 2008. The bonanza of money that was thrown at tech startups that set off SVB’s meteoric growth was one manifestation of Fed accommodation. Moreover, SVB’s decision to invest in long-duration securities was an expression of a view that interest rates would stay quite low forever. Part of the Fed’s job over the past year has been to disabuse financial market participants and the public of that view.
There were always going to have to be casualties along the way. Without a doubt, the Fed would not have wanted to see the sort of chaos that has played out over the past week or two. However, it is important to remember that some degree of tightening in financial conditions is exactly what the Fed has been trying to achieve. An overshoot is quite possible. However, a modest tightening of lending standards would not be a cause for alarm or a reason for the Fed to dramatically alter the trajectory of monetary policy.