The Big Idea
An early review of crisis response
Stephen Stanley | March 24, 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. This material does not constitute research.
I have intentionally refrained from referring to the events of the past few weeks as a banking crisis because I believe that overdramatizes the situation. From what I have seen so far, this is not 2008 or the S&L crisis or anywhere close. A few individual banks that played fast and loose with risks were found lacking when interest rates rose much more than they expected. The banking system remains, as the FOMC described, “sound and resilient.” Unfortunately, I would not say the same about policymakers’ response. While emergencies present certain heat-of-the-moment pressures that can lead to responses that look flawed in hindsight, the steps taken by authorities in this episode have been terribly disappointing.
Post Dodd-Frank
After the Global Financial Crisis, there was a broad sense that the regulatory structure in the US had failed to effectively police the banking system. As a result, wholesale changes were made, most notably in the Dodd-Frank legislation. Banks were required to hold much more capital, to maintain high levels of liquid assets and to limit their leverage. Large banks were also subjected to stress tests and required to submit living wills that laid out a path to resolution in the event of a failure. These steps were said to eliminate the Too Big to Fail problems that required repeated bailouts in 2008.
The events of March 2023 could fairly be said to offer the first strenuous test of that new regulatory infrastructure. The result has been a resounding failure. The Dodd-Frank structure worked to prevent 2008-style problems. Banks’ leverage ratios are good, their loan books are solid, and their securities portfolios did not have massive credit or default risk. However, regulators were stuck fighting the last war. The concentration of uninsured deposits at SVB, Signature and others represented a flight risk that was clearly underestimated by banks as well as their overseers. Moreover, the banks that followed the rules by holding Treasuries and agency MBS in their portfolios exchanged credit or default risk for duration risk, a foreseeable issue that regulators failed to address effectively.
To be fair, most everyone in the financial markets shared the conviction that the Fed would keep policy rates low forever. Indeed, the Fed promoted this view of the world, right up until inflation roared out of control. As late as December 2021, the FOMC dot projections showed that Fed officials expected the fed funds target rate to remain below 1% through the end of 2022 and to rise only to just above 2% by the end of 2024. So, even policymakers had no sense ahead of time of how steep the run-up in interest rates would need to be.
This was the first policy failure, and perhaps the most important one. Very few banks were geared to deal with 5% short rates, and by waiting too long to begin the normalization process, the Fed allowed inflation to take root and force the steep hiking cycle seen in 2022.
In any case, the whole point of the new Dodd-Frank regulatory structure was to prevent the need for the sort of weekend emergency bailouts seen in 2008. Unfortunately, we have apparently made little progress on that front.
Short-term versus long-term thinking
As noted above, an important element of the Dodd-Frank regulatory structure was to put in place a game plan in the event of a bank failure or other crisis moment, so that financial markets and other stakeholders would understand beforehand what the policy response would be.
Unfortunately, this did not pan out. In the immortal words of Mike Tyson, “everyone has a plan until they get punched in the mouth.” When regulators were punched in the mouth a few weeks ago, the carefully crafted plans were ripped up, and we went back into ad hoc panic mode.
Niall Ferguson and Moritz Schularick posted an opinion piece in the Wall Street Journal a few days ago summarizing an academic paper that they co-wrote. It examines the history of central bank interventions in times of turmoil. They found that for hundreds of years, central bank balance sheet expansions were employed only to finance government war efforts. It was only in the second half of the 20th century that central banks began to systematically use liquidity provision in response to financial crises.
They divided central bankers in these episodes as “hawks” or “doves.” “Hawks” have tended to oppose providing liquidity support to badly managed banks, arguing that it only encourages more risk-taking. “Doves,” by contrast, put more weight on the risk of inaction, as bank runs, if unchecked, can lead to dire economic consequences.
Their conclusions from examining 400 years of interventions were quite interesting. Both camps had a point. In the short run, doves were “right.” Output fell less and recovered faster when doves were in charge and central banks intervened aggressively. However, “hawks” were correct in the long run, as a firmer safety net invited more risk taking and raised the likelihood of a subsequent boom-bust episode.
When things seem to be falling apart, the urge to do anything and everything to stabilize conditions in the moment can be overwhelming. And to be fair, we do not know how bad things may have gotten if Treasury, the Fed, and the FDIC had not stepped in and taken steps to stabilize the banking system when they did. However, it is quite clear that the steps taken in the past few week will, at the margin, lead to heightened risk-taking in the long term.
Breaking the rules
There were a couple of developments this month that are especially likely to roil the waters, adding uncertainty as well as creating moral hazard for certain players or investment strategies.
First, the Treasury, the Fed, and the FDIC invoked a “systemic risk” exception to guarantee all deposits at SVB and Signature when they were placed into receivership. This represented a particularly troublesome move, as Congress had passed a loosening in regulatory rules precisely for mid-sized banks in 2018. The exact rationale for the bill was that these banks did not represent systemic risks to the financial system and thus did not need to be subjected to the same level of regulatory scrutiny as the largest banks. Then, when trouble hit, the authorities guaranteed these banks uninsured deposits by arguing that they did represent a systemic risk. That is bound to create confusion as well as signaling that, when push comes to shove, the US regulatory authorities will bail out all depositors.
The other especially disturbing aspect of this step is that having a deposit insurance cap is meant to create discipline in the banking system. Any depositor below the FDIC cap, which is currently $250,000, does not have to worry about whether their bank is behaving responsibly. Uninsured depositors are supposed to be the ones who are watching over their bank’s behavior, since they are subject to losing some portion of their deposits if the bank runs into trouble. If all depositors come to believe that the government will bail them out, then there will be no market discipline. Then, regulators, rather than being the last line of defense against bad behavior, will be the only line of defense. And the track record of regulators catching problems before they lead to trouble is not encouraging.
The second move that is liable to generate undesirable reactions was the Swiss authorities’ steps to resolve the Credit Suisse situation. First, the Swiss authorities ignored the plans that CS was required to draw up to resolve itself. Instead, they pressed UBS to take over CS. Both of those banks were already too big to fail. Combining them creates a behemoth that the Swiss regulators will likely not be able to properly manage. This is exactly the sort of steps that were taken in the US in 2008 when several large entities got into trouble and the federal government cajoled JP Morgan and Bank of America to take them over, created larger and larger big banks.
In addition, the Swiss regulators jumbled the capital stack, zeroing out CS’s AT1 bonds while allowing equity holders to get a portion of their investment back. As it turns out, this was likely a one-off situation, as the details of AT1 bonds issued by large banks in other European countries do not allow the maneuver taken by the Swiss. Still, while I would imagine that the Swiss had a compelling reason to do what they did, it created chaos in the global AT1 bond market for a few days and interjects more uncertainty about how future bank resolutions may play out. Again, this is very much the opposite of what post-Financial Crisis regulatory changes were designed to yield.
Conditioning the financial system
The events of this month suggest that despite over a decade of promises to the contrary after the GFC, when faced with turmoil in the banking and/or financial system, regulators will always opt for expediency and bailouts. The word that comes to my mind is “infantilize.” The Cambridge dictionary definition of this word is: “to treat someone as if that person were a child, with the result that they start behaving like one.”
In moments of crisis, regulators have treated markets in this way, giving in to whatever tantrum breaks out. And all of us who are parents know what happens when you perpetually give in to tantrums.
The swings in risk in financial markets this week illustrate the monster that regulators have created. Since the authorities guaranteed SVB’s and Signature’s uninsured depositors, various market players have been clamoring for them to extend that guarantee to all mid-size regional banks or even to the entire banking system. Treasury Secretary Yellen admitted to a Congressional Committee recently that the government does not have the authority to make that universal guarantee without Congressional authorization. Based on current law, regulators can only guarantee uninsured bank deposits of a specific bank and only after that bank fails. The headline this admission generated led to a massive selloff in equities and a sharp rally in Treasuries on Wednesday afternoon, even overshadowing Chair Powell’s post-FOMC press conference. Similarly, more Yellen headlines on Thursday led to another round of market volatility.
We are left with financial markets that believe that their best (or only) salvation is the prospect of endless bailouts. The vicious circle will continue. The more investors believe that they can bully the regulators into offering bailouts, the harder they will press. At some point, the authorities will have to push back, at which point the disruption will be so much worse than if regulators had held the line in the first place (see Lehman Brothers failure in 2008).