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Komal Sri-Kumar: SVB Failure: Lessons Learned



Not 2008, But More Pernicious in Some Ways. As the United States experienced the second and third largest bank failures in history during the same week, Treasury Secretary Janet Yellen assured the Senate Banking Committee on Thursday that "our banking system is sound". After lines formed in front of Silicon Valley Bank and First Republic Bank to withdraw deposits, she insisted that "Americans can feel confident that their deposits will be there when they need them."

The deposits were there last week only because Uncle Sam – er, taxpayers – decided to back all deposits at SVB and Signature Bank, not just the $250,000 per account insured by the Federal Deposit Insurance Corporation. First Republic was supported by $30 billion in new deposits from some of the country's largest banks in an effort that was managed – or forced? – by the US Treasury and the Federal Reserve. The move still had not brought stability to markets or to First Republic shares as of yesterday.

Is a "sound banking system" one in which government intervention is necessary at every stage to ensure that banks remain solvent and liquid? How did this situation come to pass for US banks? There were two major reasons why this happened, other than for the often-repeated view that regulators were asleep at the wheel.

First, the subprime crisis of 2007 - 2008 that regulators had been focused on when they set new regulations to limit risk for financial institutions involved the asset side of the balance sheet, viz., the quality of loans that were being extended. By this definition, holdings of US Treasurys were "risk-free" while loans of varying credit quality and rating would call for capital requirements to ensure solvency of the institutions. Problem had been solved in the regulators' assessment, and they concluded that the events of 2008 would not recur.

The problems this month, certainly in the case of SVB, arose largely from the liability side of the balance sheet. Bank officials had loaded up on long-dated "risk-free" Treasurys at very low yields. As yields rose, i.e., as prices of the bonds fell, the assets were worth less than the bank had paid for them. As depositors withdrew cash to find a home for it at even higher yields, SVB found itself having to sell Treasurys at a loss. An effort to raise capital this month to compensate for the outflow of deposits created panic rather than reassure depositors. The stock sale was canceled and depositors fled.

Second, recall that mismatching maturities was a winning strategy for banks, including SVB, as long as the Federal Reserve followed its irresponsible balance sheet expansion policy of 2021 - 2022 despite clear signs that economic growth had revived after covid, and notwithstanding a simultaneous massive fiscal expansion by the Trump and Biden administrations. At the same time, the Fed persisted with near-zero interest rates until March 2022 as Chairman Jerome Powell maintained that the pickup in inflation was "transitory". Those of us who warned of inflation remaining elevated and sustained were just fearmongers!

Quantitative Easing (purchase of bonds by the Fed) was boom time for institutions that maintained a duration mismatch because QE lowered long-dated Treasury yields, resulting in capital gains. But banks, for the most part, did not change their behavior as the feast ended last year.

As the Fed started to increase interest rates in March 2022, and announced last June that it would shrink its bloated $9 trillion balance sheet, banks did not correspondingly reduce long-term claims on borrowers. A superb analysis of banks' reaction to QE and the subsequent Quantitative Tightening is contained in a paper coauthored by Raghuram Rajan of the University of Chicago - Booth School with three others.

The maturity mismatch probably extends to a number of banks because of the profit incentive that Fed policy provided under QE to all institutions. Federal Reserve's balance sheet doubled between early 2020 and early 2022, putting an implicit ceiling on 10-year and 30-year Treasury yields. And there appears to have been no corresponding regulatory control on maturities as there had been on asset quality.

So expect more bailouts to occur. That, in turn, is likely to have two implications. Whether or not the Federal Open Markets Committee increases interest rates next Wednesday, it will be more concerned about "systemic stability" than about inflation mitigation during the rest of the year. Expect a "pause" in rate hikes soon, followed by reductions before the end of 2023. "Lower for longer" will be the new Fed mantra on interest rates.

QT? Given how it is seen to have helped start the present crisis, it wouldn't be surprising to see it dispatched and be replaced by a new round of QE. Data just released by the Fed show that the assets of the central bank increased by almost $300 billion in the week ending March 15. The latest week witnessed the asset level go back to the level last November, offsetting the QT that has occurred over the past four months. Hallelujah, it is time to rejoice again!

What are the key developments investors should watch out for in light of the developments over the past two weeks?

Should the financial crisis persist, as I expect, that would be disinflationary. Powell may eventually achieve his targeted 2% inflation rate, but only at the cost of a severe recession provoked by developments in the banking sector. As we enter the politically important election season, these developments may not find support in the Biden administration.

Since the still spreading panic in the financial sector implies a more dovish Fed policy, it is likely to result in a weaker dollar, and to support the rally that gold has experienced over the past several days. Since the largest US corporations get the major share of their revenues from abroad, dollar weakness could partly insulate them from the impact of recession.

How should US authorities react? President Joe Biden can decide to give a speech every week along the lines of what he did last Monday assuring "Americans can have confidence that the banking system is safe". Alternately, in addition to better regulation, we can replace the ongoing seat-of-the-pants monetary policymaking with a rules based structure to reduce the likelihood of future crises.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California


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Posted: March 18, 2023 Saturday 10:08 AM