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Good morning. A wild day on markets for banks stocks and interest rates but, in an comforting sign, the market as a whole was flattish. We will forgo predictions about what will happen in the days to come, but we are keen to hear yours. Email them to [email protected] and [email protected].
The regional banks
Let’s play “who’s next?” It was an ugly day for banks: the KBW bank index was down 11 per cent, and there were 10 banks that lost 20 per cent or more. There is clearly fear and speculation in the market that another bank will follow Silicon Valley and Signature into the arms of the FDIC. The worry, of course, is a run on deposits, but there is no way to see bank-level deposit activity in real time (and a good thing, too). All we can look at are share and bond prices and each bank’s financial statements from the end of the last quarter, hoping that (a) the last set of financials bears some resemblance to current economic reality and (b) depositors will not hit a fundamentally sound bank with mass withdrawals.
Below are some critical financials for the five US banks that have had the worst stock market performance since last Wednesday, plus SVB’s numbers for comparison. Because SVB’s problem was flighty, uninsured commercial deposits paired with an asset portfolio stuffed with securities nursing losses, I have focused on those points:
The leverage ratio is calculated above as tier 1 equity capital divided by total assets. This gives a rough and ready sense of each bank’s loss-absorbing capacity. Notice I don’t risk adjust the assets; part of what got us into this mess is that government bonds have a good risk rating, ignoring their interest rate risk. A risk ratio of 8-9 per cent is pretty normal for the industry. Zion’s ratio is a shade low, then, but not terrifying. Next, plain old cash as a proportion of assets — in a bank run, nothing beats the cash. None of these banks has loads of cash as compared to some of the very large banks (JPMorgan has 15 per cent of its assets in cash, for example). So this may explain some of the beatdown.
Next, insured deposits as a percentage of total deposits, a proxy for the “stickiness” of each bank’s deposit base. None of these guys are remotely in the same risk category as SVB on this metric, though you can still understand concern at First Republic and Western Alliance. With securities as a percentage of assets SVB was in a whole different class.
Finally, all the way to the right-hand side, is the leverage ratio adjusted for the unrealised losses on each bank’s security profile (that is, subtracting the losses from both capital and assets). This gives an indication of what might happen if the losses had to be crystallised in a sale, which would hit regulatory capital. And all five of the banks would still be solidly solvent (if their marks were accurate as of the end of 2022). This was emphatically not the case with SVB. To repeat what we have been saying for several days, SVB looked and still looks like an outlier, in a lot of ways.
Of course, this handful of numbers cannot tell us about all the risks these banks face. For example, First Republic is under so much actual pressure in part because it has a large portfolio of home mortgages that, like SVB’s bond portfolio, is a big, illiquid drag on yields. But the general point remains that even the banks getting the worst whipping look very different from SVB. Yes, enough panic can bring down any bank; yes, there may be more small banks with idiosyncratic problems that could fall over; but yes, the system looks OK. Crises are impossible to predict, but this one isn’t spiralling yet, and given what we know now, that makes sense.
Where might our calm view of overall banking system stability be wrong? One possibility is that a two-tiered bank regulatory regime, like the one the US set up after the great financial crisis, is inherently unstable, and we are only now finding this out. The so-called systemically important banks are subjected to higher capital and liquidity requirements than the rest, as well as more frequent stress tests. Perhaps under significant financial system stress, this will cause a persistent risk of bank runs, as uninsured depositors leave regional banks and head for JPMorgan or Bank of America. Maybe this will just keep happening in this cycle until rates and rate volatility come down, causing a slow-motion banking crisis. I don’t expect this to happen, but it could.
Moral hazard. Does the authorities’ resolution of SVB and Signature risk moral hazard, and how worried should we be about this? There is a great deal to say about this, most of it hard to say it until we have more details about how the resolutions will work (a sale of SVB is still possible, apparently) and whether more banks will need to be resolved. That uninsured depositors have been promised 100 cents on the dollar sure looks like the top of a slippery slope, but we will wait and see.
But part of the fear of moral hazard is based on an incorrect view of how companies work. If uninsured depositors expect to be bailed out, the thinking goes, depositors will behave recklessly. They just throw their money into any damn bank, removing an important incentive for banks to manage themselves prudently. That is, lower deposit costs for well-managed banks create more profits for shareholders, so banks will be motivated to manage prudently, maximising profits over the long run.
This view is largely based on the archaic idea that public companies are run for the benefit of their owners, the shareholders. They are not. They are run for the benefit of the people who are doing the running, that is, the management team. Shareholders have to hope, or work to ensure, that management’s interests line up with their own. Banks are prudent, in other words, because the executives want to get paid a lot for as long as they can, not because if they are imprudent deposits will become expensive and the share price will fall, or anything like that.
(As a side note, the SVB failure is surely proof that even the CFOs of the “smartest” companies do not pay attention to, or do not understand, the risk profiles of the banks where they keep their companies’ money.)
If you believe that public companies are operated in order to get executives paid as much as possible for as long as possible, then you also believe that a lot of the work of incentivising prudence is done by firing management teams and wiping out their shareholdings when things go wrong, as has happened with SVB and Signature. This does not provide a perfect incentive for prudence, but it’s a start.
A whole new world of rates
The weekend’s tension in the banking sector spilled immediately into rates markets on Monday, with violent results:
Futures market expectations for the peak fed funds rate fell from 5.3 per cent on Friday to 4.8 per cent yesterday.
Significant cuts are now priced in, bringing the fed funds rate to 3.9 per cent by year-end. On Friday, that year-end rate was 4.9 per cent.
The policy-sensitive two-year yield collapsed 60 basis points yesterday, at one point brushing below 4 per cent. As recently as Thursday, the two-year opened above 5 per cent.
The 10-year also fell 18bp, coming down nearly 50bp in two trading days.
The result is a much steeper yield curve. The 10/2 yield spread widened more than 40bp, though it remains deeply inverted. This makes sense. The big question now is: will SVB snowball into a broader financial disaster? If yes, the Fed will probably cut rates, as it has in crises past. Thus the tumbling two-year. But as we wrote yesterday, even if the SVB fallout is contained, the Fed is now constrained. And as one rates strategist noted to us yesterday, a constrained Fed means the risk of stubborn inflation for longer has risen, so a risk premium needs to be priced into long yields. Thus the steeper curve. Even if markets overshot yesterday, they look directionally right.
Dramatic moves make for dramatic calls. Witness this note from Nomura’s Aichi Amemiya, revising his view on next week’s Fed meeting. In a few days he’s gone from expecting a 50bp increase to expecting a 25bp cut and an end to quantitative tightening. Here’s Amemiya’s rationale, laid out in a note yesterday:
Financial markets seem to view [US authorities’] policy actions as insufficient, as stock prices for the US financial sector continue to decline as of this writing … deposit flight might not slow anytime soon for a number of reasons. Despite the FDIC’s [actions] corporate depositors are still concerned about a loss, even temporarily, of access to their deposits from the bank(s) going under conservatorship, even if they are made whole later. Second, ironically, the sensitivity of individual depositors to deposit rates might have increased due to the FDIC’s announcement of making all Silicon Valley Bank’s depositors whole. We could see a significant outflow from commercial banks, which may compel banks to liquidate their loan portfolios unless banks raise their deposit rates substantially. Third, on banks’ securities investment, unrealised capital losses in the banks’ held-to-maturity portfolio might not become an imminent issue because of the Fed’s new BTFP. However, if the Fed keeps the policy rate “higher for longer”, banks would be averse to liquidating securities holdings for which selling would realise losses in securities any time soon …
Although a 25bp rate cut seems unlikely to be a panacea for financial institutions, [markets pricing in further rate cuts] could somewhat reduce the risk of further bank runs, as well as reduce unrealised capital losses … financial stability risks are quickly becoming a dominating factor for monetary policy.
So far, Amemiya is alone here. Most big-bank economists still expect a 25bp rate increase this month. But a growing number — including those of Barclays, Goldman Sachs and NatWest — see a pause. Markets, which on Friday ignored the possibility of a pause, now give it a one in three chance. Speaking after yesterday’s close, Don Calcagni, chief investment officer at Mercer Advisors, told us that cuts risked muddying the Fed’s communication strategy, signalling the central bank sees more trouble in the financial system than it is letting on. But he agrees that financial stability fears are now a meaningful constraint on the Fed. He expects a pause too.
We’re not sure. Our doubt has two sources. One is that the world that existed a week ago has not vanished. Inflation is still hot (as today’s CPI report will remind us) and the economy is still strong. Unless inflation really starts to budge, the Fed will be loath to use rates as its instrument to shore up the financial system, especially given its power to fashion liquidity facilities out of thin air.
The second is that the types of financial wreckages that have forced rate pivots before have been extremely bloody. The chart below, from Absolute Strategy Research’s Ian Harnett, plots major crises next to the fed funds rate:
Does SVB seem on par with the others? For reasons laid out in the past few days, we’re still sceptical (while acknowledging that the whole point of crises is that they are full of surprises). What seems likelier than an imminent halt to the rate-hiking cycle is a gradual pace until inflation is conquered or, as Harnett puts it, “there is enough blood on the street”. In that sense the bond market probably overshot yesterday, and may soon correct. Mercifully, Fed officials have more than a week to let the dust settle and think through their next move. The bond market has no such luxury. (Ethan Wu)
One good read
The psy-op against Taiwan.
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