Recent instability in the banking sector has caught many in and around the industry off guard, but for some economists, it was the outcome they were expecting.
Few could have precisely predicted the failures of Silicon Valley Bank and Signature Bank, the voluntary wind-down of Silvergate Bank and the distress of First Republic Bank — all in less than two weeks — but many Federal Reserve watchers had warned that the central bank's rapid interest rate hikes last year were setting the financial system up for devastating ripple effects.
"This is the credit event that I have been anticipating," said Komal Sri-Kumar, a senior fellow at the Milken Institute and independent macroeconomic consultant. He noted that the underwater Treasury securities portfolios at the affected banks bear a resemblance to the sovereign debt holdings that wreaked havoc on several large U.K. pensions last September.
"No two crises are identical, but there are similarities," Sri-Kumar said.
Sri-Kumar first grew
With uncertainties still reverberating through the banking system, Sri-Kumar said the Fed will be hard-pressed to raise rates again at this week's Federal Open Market Committee meeting.
"Forget about inflation — that's not my primary worry," he said. "I can't worry about inflation at this stage if I'm the chairman of the Federal Reserve. I have to worry about saving the system."
Yet, if the stability of the financial system is a concern for Fed Chair Jerome Powell, he has not indicated it in the limited remarks the central bank has released during the ongoing uncertainty in the banking system.
"The capital and liquidity positions of the U.S. banking system are strong, and the U.S. financial system is resilient," Powell and Treasury Secretary Janet Yellen wrote in a brief written statement Sunday after the Swiss central bank announced it had brokered an
The Fed does not factor potential financial stability implications into its monetary policy decisions, but any changes to monetary policy are predicated on the system being sound enough to handle them. During last year's sprint to tighten monetary policy, Powell said on
Interest rates, which ticked up to 4.75% last month, remain low by historical context. But the speed at which they have changed has not been seen since the 1980s. That velocity of change can be difficult for banks and financial institutions to anticipate let alone adapt to, said Claudia Sahm, a former Fed economist who also raised concerns about the central bank's policy changes last year.
"Banks probably should have seen rate increases coming, but at the fastest speed since [former Fed Chair Paul] Volcker? That was not what the Fed was signaling. That wasn't the consensus," Sahm said. "The size and the speed together created an environment that people, in hindsight, made some very bad decisions in terms of their portfolios, but there was just a very short period of time for everyone to adjust."
The impact of interest rate changes — and the failure to manage them — appear to have been acute for at least one of the affected banks. Santa Clara, California-based Silicon Valley Bank had more than $15 billion of unrealized securities losses in its held-to-maturity portfolio. The bank had nearly doubled its securities holdings from $67.1 billion in March 2021 to $124.7 billion in March 2022.
Higher interest rates cause the market prices of older bonds to fall because they offer lower annual payments than newer ones. The bank did little to hedge this risk in its Treasuries portfolio, which could have been done by purchasing shorter-term bonds to reduce its duration risk or purchasing derivatives, such as credit default swaps. The Fed and other regulators regularly encourage banks to manage interest rate risk diligently.
Silicon Valley Bank was forced to sell some of its depressed assets to satisfy withdrawal requests, crystalizing $1.8 billion of losses. The bank attempted to raise $1.75 billion in fresh equity to offset the losses on March 9, one day after the San Diego-based crypto bank Silvergate announced its plan to self-liquidate amid its own liquidity crunch — triggered by the collapse of the FTX cryptocurrency exchange last fall. Silicon Valley Bank's capital raise failed, and its stock value plummeted 60% in a single day.
Customers of Silicon Valley Bank, most of whom were venture capitalists or venture-backed startups with deposits exceeding the Federal Deposit Insurance Corp.'s $250,000 guarantee, quickly headed for the exits. A staggering $42 billion run prompted the FDIC to shutter the institution on March 10.
New York-based Signature Bank failed two days later amid mounting withdrawal requests over the weekend. The Fed, FDIC and Treasury Department declared a
Despite these actions, regulators had to step in once again to stem contagion. They arranged for 11 of the nation's largest banks to
Silicon Valley Bank's balance sheet appears to be distinctly mismanaged and the precipitous drawdown of its deposits was unprecedented, but it was hardly the only bank to load up on long-dated bonds — to take advantage of their higher coupon payments — when interest rates were at record lows. In a speech earlier this month, FDIC Chair Martin Gruenberg said banks were collectively carrying more than $620 billion of unrealized losses at the end of 2022.
Fed critics say these losses are being driven by investments that were supported by the Fed's expansionary monetary policy. Now that monetary policy has become restrictive, those same assets have fallen out of favor. When rates were low, banks were incentivized to take on duration risk. At the same time, the Fed was expanding its balance sheet through asset purchases — an exercise known as quantitative easing, or QE — giving banks both a surplus of reserves to fall back on and a strong market to sell long-dated securities, should they need liquidity.
Under quantitative tightening, or QT, which the Fed began last June, those supports fall away.
"Quantitative easing enabled a great deal of yield chasing across the financial system that was going to prove very difficult to wind down," said Karen Petrou, managing partner at Federal Financial Analytics. "And we're seeing that exactly."
Raghuram Rajan, a former governor of the Reserve Bank of India and a current finance professor at the University of Chicago, said the demise of Silicon Valley Bank is emblematic of the shift in bank funding that takes place when the Fed goes from quantitative easing to quantitative tightening.
Rajan authored a paper last year on the liquidity implications of unwinding a central bank's balance sheet. He presented the paper along with his co-authors Viral Acharya of New York University, Rahul Chauhan of the University of Chicago and Sascha Steffen of the Frankfurt School of Finance and Management at the Fed's Jackson Hole Economic Symposium in late August.
Their research found that quantitative easing encourages banks to take liquidity risk on both sides of their balance sheets. In the case of Silicon Valley Bank, Rajan said, it was more willing to add duration risk to its assets while relying on highly liquid liabilities in the form of demand deposits, rather than more expensive but stickier time deposits. The issue, he said, is that quantitative easing creates a "liquidity dependence" that banks cannot shake off when the Fed begins tightening again.
"The sequence of QE and QT doesn't happen automatically," Rajan said. "Janet Yellen once made the point that QT will be like watching paint dry. And what we're saying is 'No, no, it's not that simple,' because the banks are out on a limb and it actually can create problems. We saw it in September 2019, we saw it in March 2020, and we're seeing now in March 2023. QT is part of the problem."
While the speed of the Fed's monetary tightening last year appears to have added stress to at least parts of the financial system, Petrou said the swift action was a second-order effect of the central bank's failure to begin combating inflation in a timely manner. Had it begun raising rates sooner, she said, it could have done so more gradually.
Petrou said the distress of this episode is already reverberating globally, noting that it is not a coincidence that the long-running issues at Credit Suisse came to a head after the bank failures in the United States.
"Once the markets start thinking about a point of fragility in banking, they stop assuming that all points of fragility in banking will remain secure," she said. "Technically, this is called the
