Mon, Mar 13, 2023

The Federal Reserve Rides to the Rescue

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Over the weekend, policymakers scrambled to shore up confidence in the banking sector after Silicon Valley Bank (SVB) had been put into receivership on Friday and New York’s Signature Bank was suddenly closed on Sunday. SVB and Signature Bank both had a depositor base that was largely uninsured. As no white knight came forward over the weekend to buy the U.S. failed banks, the Federal Reserve, U.S. Treasury and Federal Deposit Insurance Corporation (FDIC) put together a rescue package. Unlike in 2008, the bailout of these banks was not of equity or bondholders, but only of depositors. All depositors (including uninsured depositors) will be made whole and the Fed has created the Bank Term Funding Program (BTFP) to allow banks to borrow from the Fed using Treasury bonds as collateral and valuing them at par, which should help in liquidity squeezes. Here’s a quick explainer of what policymakers have put in place and what it means for Fed policy and the U.S. economy.

What Policy Moves Were Made to Shore Up the Banking Sector and Will They Work?

The Fed, Treasury and FDIC agreed on Sunday that the banking wobbles unfolding over the past few days had reached a “systemic level” and the Federal Deposit Insurance Fund (DIF) would guarantee insured and uninsured depositors. The Fund has $125 billion (bn) and it can borrow another $100 bn from Treasury. The statement suggests that the ultimate costs will be paid for by banks via the levy on them for deposit insurance.

The Fed set up a new borrowing facility, the Bank Term Funding Program (BTFP) offering loans of up to one year in length to banks, savings associations, credit unions and other eligible depository institutions, pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. The assets will be valued at par, so that banks won’t have to sell U.S. treasuries at a loss in order to redeem deposits as was the case for SVB. According to the FDIC, banks had about $600bn in unrealized losses on U.S. Treasuries and MBS at the end of 2022. The Fed would be taking on securities that have lost value as interest rates have gone up, but the Fed doesn’t have to mark-to-market. In the event a bank does not repay its loans to the Fed, the Fed could hold the collateral to maturity, when it would be redeemed at par. The Treasury has guaranteed $25bn in lending through the BTFP using the Exchange Stabilization Fund.

The BTFP is sort of a disguised version of the discount window with slightly different terms (the discount window is only for 90 days instead of a year and it normally imposes a haircut of 5% on collateral though this haircut has been suspended). The Fed came up with a new facility in part because the discount window has a stigma. The idea is to create a lending program banks will use…and hope they don’t have to.

As I wrote last week as SVB went into receivership, any haircut on uninsured depositors was likely to prompt businesses to yank their cash out of community banks and hand it over to one of the systemically important larger institutions. It was therefore crucial that all depositors be made whole or else a bank run on smaller banks seemed likely. This has been achieved. Furthermore, the Fed has put in place a lending facility that prevents banks from having to crystallize all the unrealized losses on their books. This should help ameliorate liquidity issues, which is what SVB had before a bank run created a solvency issue.

But bank runs ultimately come down to psychology. The Fed, Treasury and FDIC have done enough to stem contagion, assuming people understand what they have done. If there are additional bank failures, it will be because the implications of the policy actions over the weekend were not comprehended. The pre-market trading on Monday morning suggests equity shares for a number of community banks will open significantly down. But this may turnaround as everyone wraps their heads around the policy response.

What Does This Mean for Fed Policy?

Goldman Sachs changed its forecast for the Fed Funds rate on Sunday to reflect a pause in rate moves at the next FOMC meeting this month (but additional hikes thereafter). I disagree and expect the consumer price inflation (CPI) data and producer price inflation (PPI) data out before the next Fed meeting will be a much bigger determinant of the Fed’s rate moves than any financial wobbles over the past few days—again, assuming that contagion is stemmed enough to avoid a banking crisis. Goldman is not the only one, market-based pricing for the Fed Funds rate suggests a reassessment of rates lower.

The Fed, like all central banks, has distinct tools for macro policy and financial stability. It can simultaneously hike rates and also extend cheap loans to banks to support them. This is not unprecedented—the Bank of England had to provide quantitative easing last fall in the midst of a rate hiking cycle in order to smooth over a blow-up in the pension sector after 10-year government bond yields spiked. Moreover, there is not much left in the Fed’s toolbox beyond what has been announced to stem this crisis. It could stop shrinking its balance sheet, but I’m not sure why this would be more convincing than the policies the Fed has already announced to stem contagion. Shifting its rate path would be an inappropriate way to address financial stability in this case.

The thinking behind a renewed Fed pivot is that the central bank has hiked rates until something broke, and SVB is what broke. Higher rates prompt investors to move their money out of deposits and into money market funds or Treasuries where they can get a higher yield. Banks end up having to offer higher rates on deposits to attract depositors, which eats into their profits. With profits squeezed, banks are also pickier about the terms of their loans, which tightens financial conditions. This is how monetary policy transfers through the banking system into the real economy.

I would be a lot more sympathetic to this argument that financial instability has been caused by Fed tightening if SVB and Silvergate (the bank for crypto, which failed before SVB) weren’t so idiosyncratic. They were fairly unique in their exposure to interest rate risk, not only because they had loaded up on government bonds but more importantly because their client base was overwhelmingly a phenomenon of cheap money. In SVB’s case, there was also shockingly little interest rate hedging of the balance sheet. Most banks extend loans rather than buy bonds and have a client base that is more diverse and less reliant on interest rates being low.

I expect the financial stability concerns will take a 50 basis point hike by the Fed in March completely off the table, but I never thought a reacceleration of rate hikes was likely this month anyhow. I forecast the Fed will hike interest rates by 25 bps in March and again in May and June. Once rates are at 5.5%, I expect the Fed to hold them there for the remainder of the year. If I am wrong about the Fed’s move in March, it is more likely to be because of a big surprise in the inflation data out this week rather than because of the banking sector.

What Are the Other Implications of the Policy Moves?

If depositors are made whole and banks are not forced to crystallize unrealized losses, the impact on the economy of the financial sector instability over the past few days should be limited. The major concern of forcing a haircut on uninsured depositors from a macroeconomic (rather than a financial stability) perspective was that a number of companies wouldn’t be able to make payroll and firms would go under. That would have been a drag on consumption and could have caused the labor market to deteriorate. Assuming that contagion is stemmed, the biggest impact of SVB’s collapse could be to consumer confidence, but this should be temporary.

There will be significant implications of recent events for the regulation of small- and mid-sized banks. As I mentioned on Friday, SVB (like most community banks) was not forced to implement Basel III regulations and so wasn’t subject to liquidity coverage ratios and net stable funding ratios. The assumption was that smaller banks were not systemic institutions. Now that the demise of SVB, Silvergate and Signature has been declared systemically important, this assumption will be revisited. The banks were not systemic in life, but they are now in death. Smaller banks will almost certainly face more regulation going forward. The downside is this is likely to push even more activity out of the banking sector and into the shadow banking system. Regulators and policymakers have little visibility on what is happening under the hood in shadow banking and so the probability of more market blowups may rise significantly.

The Fed, Treasury and FDIC have done enough to stem contagion from the bank failures we’ve seen over the past few days and thwart a financial crisis, assuming the new policies they put in place are reasonably well understood. There may continue to be volatility among smaller banks over the next few weeks, but depositors should be reassured that they will be made whole and that banks are much less likely to see liquidity squeezes turn into insolvency. The failure of SVB and Silvergate were idiosyncratic events given their clientele and their funding structures. While there will be implications for the regulation of smaller banks going forward, the impact of recent financial stability on U.S. economic growth, inflation and the Fed’s rate moves should be limited.

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