The Fed passes the first test of its inflation resolve
The Federal Open Market Committee’s (FOMC) decision to boost the federal funds rate by 25 basis points represents the first major test of its commitment to curtail inflation. The Fed’s challenge was to demonstrate its resolve while maintaining confidence in the financial system amid the sudden collapse of Silicon Valley Bank (SVB) and the fallout for regional banks. It indicated “additional policy firming may be appropriate,” but did not commit to a future course of action and acknowledged credit could become tighter.
What transpired in the past two weeks is truly exceptional. When Federal Reserve Chairman Jerome Powell testified before Congress on March 7 and 8, he stated that the Fed’s over-arching goal was to bring inflation back down to its 2 percent target. Investors took note and priced in a 50-basis point rate hike at the March FOMC meeting. Then, two days later when SVB failed, investors weighed the possibility the Fed might pause.
Leading up to this week’s meeting, Powell and Treasury Secretary Janet Yellen cited actions that were taken to protect the financial system. They include protecting all deposits of SVB and Signature Bank and establishing a program that allows banks to swap Treasuries and mortgage-backed securities at par values for cash.
Amid this, what is most striking is how perceptions of the U.S. banking system have changed overnight among investors. This showed up as a flight to quality in which short-dated Treasury yields fell by more than 100 basis points and 10-year Treasuries by 50 basis points.
At the start of this year, the banking system was perceived to be solid and capable of handling Fed rate hikes. The main reasons are the largest banks are well capitalized, and they are subject to strenuous stress tests designed to ensure they can survive runs on their funding sources. They are a product of Dodd-Frank regulatory reforms in the wake of the 2008 financial crisis that highlighted the role played by systemically important financial institutions (SIFIs).
But the environment for regional banks is now perceived to be shakier. One reason is that in 2018 Congress granted a waiver of stress tests for them on grounds they were not systemically important. But it is not clear that the stress tests the Fed was conducting last year would have identified a problem. Former Fed official Thomas Hoenig contends that risk-based capital measures did not take into account duration risk — the sensitivity of bank balance sheets to interest rate changes.
As more information has come out about SVB, one thing it clear: It failed due mainly to a huge mismatch in the duration of its assets and liabilities in an environment of rising interest rates rather than to credit problems Roger Lowenstein observes that SVB’s failure is reminiscent of problems that savings and loans encountered in the 1980s.
There are also aspects of SVB’s business model that made it very unusual. Michael Cembalest of JPMorgan notes that SVB was “in a league of its own” compared with other banks in several respects: Its ratio of loan and securities to deposits was extremely high; it had a very low ratio of retail deposits to institutional deposits; and its ratio of uninsured deposits was exceptionally high. These attributes left SVB vulnerable to a run when a prominent Silicon Valley venture capitalist firm reportedly tweeted SVB’s largest depositors to pull funds.
While it is easy to fault SVB’s senior management for the risks the bank was taking, the Federal Reserve also bears responsibility. It supervised and regulated SVB, and its bank examiners failed to react to red flags, including a large asset-liability mismatch and doubling of its assets in two years. Some observers may wonder if it is another example of “regulatory capture,” as its CEO Greg Becker had served as a director of the San Francisco Fed until it collapsed.
From this perspective, SVB is a classic example of idiosyncratic risk. But there is also a common factor that has made regional banks riskier. Namely, as interest rates have increased and the yield curve has inverted, their net interest margins have worsened and the market value of their bond portfolios has declined. As a result, deposit runs could spread to other regional banks.
While some commentators believe the Fed should have refrained from tightening monetary policy to stave off a bank crisis, I believe it made the correct decision. Had it equivocated and not raised rates, investors may have concluded that the Fed did not believe its own message that the banking system is fundamentally sound.
This does not mean it will be easy to steer monetary policy ahead. Indeed, the Fed’s job has become tougher, as investors worry about the banking system and pending downgrades of six regional banks by Moody’s. Small-midsize banks account for about 40 percent of total bank loans, and their ability to extend credit has been compromised, which could weaken the economy.
Some observers believe that what has happened will cause investors to question the viability of regional banks over the long term. Meanwhile, Congress will likely review whether it should enact legislation to insure more than $250,000 in bank deposits. Daniel Turullo, the former Fed official in charge of bank regulation, believes the most likely outcome will be greater regulation and oversight of regional banks. In the end, this could result in a new wave of consolidations by the largest financial institutions.
Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books, including “JPMorgan’s Fall and Revival: How the Wave of Consolidation Changed America’s Premier Bank.“
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