The recent collapses of Silicon Valley Bank, Silvergate, and Signature Bank in the United States, which spilled across the pond to Credit Suisse, embody the consequences of the sharp change of direction in monetary policy and business cycles that began in 2022.
Rising interest rates, intended to contain inflation, have created a series of challenges. These include businesses’ increased need to draw down cash as external funding dries up, the popping of highly speculative bubbles (crypto, anyone?), the drop in the value of fixed-income securities as higher-yielding options become available, the inevitable impact on financial markets and balance sheets, and the drag on economic activity of rising uncertainty.
None of these developments should come as any surprise to observers of the consequences of interest rates and business cycles and the resulting financial asset volatility. Unless they were living under a pile of rocks, investors, management teams, and boards have known for quite some time that US interest rates are rising.
In other words, these have all been obvious, probable, gray rhino risks, not unimaginable black swans. (Check out this graphic from Korea’s Chosun newspaper showing a gray rhino standing atop Silicon Valley Bank with a small black swan on its back.)
I’ve been talking for quite some time about how such loose monetary policy for so long has created financial fragilities, and many of the economic and market observers whom I respect have been doing so too.
Close observers of the banks that ran into trouble sounded warnings specific to those institutions that may not have gotten wider attention. So, while most people would have had a hard time predicting exactly where the expected consequences of tightening monetary policy would erupt, the general trend has been clear.
So it’s important to view the recent bank collapses as part of a bigger story –a crash of gray rhinos around us and still ahead of us.
The recent bank failures are merely a symptom. Hopefully, they also are a warning signal that can prompt proactive responses to mitigate further turmoil which some observers describe as the end of the “everything bubble.”
As more information comes out about how events unfolded at the troubled banks in question, who knew what when, and where systems broke down, they can be a case study of lessons that investors, businesses, and policy makers can and should apply to the future. Today I’ll point to some of the next gray rhinos in line, and will address some of the case study lessons in a later post.
More Gray Rhinos to Come
The swift contagion from Silicon Valley to Credit Suisse is a reminder of the global nature of capital market fragilities. (Remember the “US” problem with subprime loans that triggered the Great Financial Crisis?) Some observers have tried to downplay the linkage between the US banks and Credit Suisse, but that is wishful thinking. In reality all banks, everywhere, with even a hint of trouble are now facing extra scrutiny.
Nervous depositors have shown that they are ready to pull out their money at the slightest hint of trouble. That trigger could be the comments of a significant investor (as in Credit Suisse). Or it could be losses on securities that had to be sold to meet redemptions –even if those losses are small compared to the size of the bank (as with SVB).
According to the FDIC, US banks are sitting on roughly $620 billion in unrealized losses like the ones that only appeared on Silicon Valley Bank’s balance sheet when it sold US Treasury securities that had been on its books at face value rather than market value. As FDIC Chairman Martin Gruenberg told the Institute of International Bankers on March 6, “Unrealized losses on securities have meaningfully reduced the reported equity capital of the banking industry.” In other words, many banks may need to raise additional capital to back up their deposits.
A new paper by Erica Xuewei Jiang, Gregor Matvos, Tomasz Piskorski, and Amit Seru, “Monetary Tightening and U.S. Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?” argues that recent drops in the value of bank capitalization “very significantly increased the fragility of the US banking system to uninsured depositor runs.” They estimate that the market value of U.S. bank assets is $2 trillion lower than their book value. On top of unrealized hold-to-maturity losses, mark-to-market assets are down an average of 10 percent across the system. The authors pointed out that SVB was not the worst capitalized bank, with 10 percent of banks having lower capitalization (though nowhere near as much in higher uninsured deposits as SVB).
Concerns about depositors moving their money from smaller regional banks to larger banks perceived to be “safer” prompted Treasury Secretary Janet Yellen to announce this morning that the US is prepared to do more to protect deposits at smaller banks.
Some observers also worry about the potential for increased concentration in the banking industry. A flight to perceived safety at larger banks could threaten smaller banks, which tend to know their customers better than the giant banks do –and thus better at assessing creditworthiness and more flexible when merited. Banking concentration could make the bigger banks even more systemically important and risky.
In addition to losses in securities that have lost value, banks are vulnerable to loans involving commercial real estate. That $20 trillion market has been hit hard by the shift to work-from-home and hybrid working arrangements because of the pandemic, and by widespread layoffs in tech (and presumably, in other industries, to come as the economy weakens). This year around $270 billion worth of commercial real estate loans are due to mature and thus likely will need refinancing at higher rates.
Lenders also could be hit by defaults and other losses on leveraged loans to riskier companies with lower credit ratings.
Emerging market borrowers also are extremely vulnerable to rising U.S. interest rates, a stronger dollar, and a risk-off mood –a dynamic I observed up-close, day-to-day and often minute-to-minute very early in my career. What’s more, many low-income countries already were struggling after taking hard hits from the Covid-19 pandemic because they did not have the resources that developed countries did to support their economies.
Continued nonsensical squabbling over the US debt limit and the possibility –once unspeakable—of a US default, even a technical one, adds to this dangerous crash of gray rhinos.
The Fed’s Dilemma
The US Federal Reserve now faces a dilemma: whether/how much to continue increasing interest rates to fight inflation or to pause or end hikes in order to avoid cascading effects on banks, budget deficits, (un)employment, and more.
The Fed’s next interest rate decision tomorrow will give some insight into its thinking and into how much confidence the financial markets have in the central bank’s policies.
First is whether the economy and banking system are strong enough to handle more rate increases. Second is whether its fight against inflation is succeeding and whether weakness in the banking system will finish the job –or whether we are in for deeper economic uncertainty and recession alongside inflation.
Once the Silicon Valley Bank collapse happened, policy makers were considerably quicker to respond than they had been earlier in the game as warning signs appeared. Now the progression or averting of this crash of financial gray rhinos depends on their response and on that of banks, investors, and businesses to the troubles they anticipate.
As I often say, it’s not just about identifying or spotting risks: it’s about evaluating the response (or lack of it) and the consequences of those responses. Once the dust settles it will be important to hold accountable those who saw the problems coming and failed to act appropriately. More on that soon.
UPDATE March 24: Read an early assessment of Lessons that Bear Repeating HERE.
This article is part of my LinkedIn newsletter series, “Around My Mind” – a regular walk through the ideas, events, people, and places that kick my synapses into action, sparking sometimes surprising or counter-intuitive connections.
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- Banking Crisis Part II: Some Obvious Lessons that Bear Repeating - March 24, 2023
- Banking Crisis: A Crash of Gray Rhinos - March 21, 2023
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