Sunday, April 02, 2023

To QE or not QE? That is the SVB crisis question!

Andrew Sheng and Tan Yi Kai/The Edge Malaysia

March 21, 2023 13:45 pm +08

The sudden collapse of Silicon Valley Bank (SVB) has sent shock waves and ripples from the US outwards. Two other American banks have also closed, one voluntarily (Silvergate Bank) and the other (Signature Bank) was taken over by the Federal Deposit Insurance Corporation (FDIC), causing even Japanese bank shares to tumble for a few days. 

Credit Suisse is now embroiled in the contagion. Even as the US Treasury, Federal Reserve and FDIC raced over the weekend to stop contagion by guaranteeing all deposits exceeding the US$250,000 (RM1.1 million) deposit guarantee limit, serious questions were being asked. 

Where did SVB slip up? Was this a regulatory failure? Is this systemic with worldwide implications? 

SVB was the 547th American bank to have fallen since 2003, but most of the others were small. With US$209 billion in assets, it was the largest bank to go under since Washington Mutual  (US$307 billion in assets) buckled in 2008, under reckless mortgage lending. With US$110 billion in assets, Signature Bank was the third largest bank failure in the US. 

Ironically, SVB was a victim of its own success, killed by poor risk management. From 2019 to 2021, it reaped the benefits of being a major banker to tech start-ups when the tech boom and fundraising saw its customer deposits triple from US$61.8 billion to US$189.2 billion. Since SVB could not lend out fast enough, it parked those liquid funds in long-dated mortgage-linked securities and US Treasuries. Trouble began last year after the Fed hiked rates by more than 400 basis points (bps), crunching liquidity that led start-ups to burn through their cash, some of which was kept at SVB.

The increase in interest rates also had a massive balance sheet impact on institutions holding long-term securities. FDIC chairman Martin Gruenberg warned as late as March 8 that US banks were sitting on US$620 billion of unrealised losses on these instruments. To meet deposit withdrawals, SVB had to quickly liquidate its holdings, and the more it sold, the more losses were realised. SVB disclosed a loss of US$1.8 billion and belatedly tried to raise additional capital. By this time, all hell had broken loose. As tweets spread across the tech community, a single-day bank run of US$42 billion brought down SVB and the FDIC took over on March 10.

Regulatory oversight should be questioned. After the 2008 reforms in bank supervision under the Dodd-Frank laws, bank capital, liquidity and total leverage rules were tightened roughly in line with the Basel III supervisory principles. Unfortunately, smaller banks like SVB lobbied for exemptions on these regulations. The liquidity coverage ratio (LCR) and net stable funding ratio applied to all bigger banks except for banks that had less than US$250 billion in assets. Both SVB and Signature Bank received less oversight.

The LCR is a globally accepted standard to ensure banks have high-quality liquid assets to meet sudden cash outflows for a 30-day period. Malayan Banking Bhd, whose asset size is roughly that of SVB, is required by Bank Negara Malaysia to hold 100% LCR but had 145% at the end of last year.

Still, no bank can ordinarily withstand a shock demand to give back US$42 billion in one day.

All banks suffer from maturity mismatch and interest rate risks. In bond parlance, SVB held securities with very long durations, financed by short-term deposits. The bank’s portfolio of mortgage-backed securities (MBS) had an average yield of about 1.5% and a maturity of 10 to 30 years. When the Fed raised interest rates to over 4% per annum, the market losses of these positions would have been US$15 billion, but were unrealised. However, if depositors wanted their money back, the sale of these securities for liquidity would make the losses real, leaving the bank short of capital. Failure was unavoidable.

Wells Fargo, one of the big four US banks, had US$50 billion in unrealised losses on its debt securities book, which is 8% of all unrealised losses among FDIC-insured banks. But no one believes that the Fed would allow such a large bank to fail. That is why fear coalesced around smaller regional banks, such as First Republic Bank, whose share price fell as much as 60% after the SVB news broke. 

Institutional risk analyst Chris Whalen, famous for calling out the subprime mortgage crisis in 2007, argued in his blog post “QE & the Yellen banking crisis” that the Fed and the Treasury should have known that when the Fed raises interest rates by over 400bps in one year, the financial system would be in deep trouble. Furthermore, by differentiating between big and small banks, regulators inadvertently created a flight of deposits to bigger banks. Smaller banks would be forced to compete by raising deposit rates to attract more uninsured deposits (above the US$250,000 guarantee threshold) to protect their turf, which in turn increases their loan rates as well.

On the other hand, giving blanket deposit insurance coverage to all banks is in essence a blank cheque for the Fed to extend quantitative easing (QE) and transfer all the interest rate risk of long-term bank assets to the central bank’s books. Even The Wall Street Journal thought it controversial for the government to claim that such a blanket guarantee to help banks would not cost taxpayer money. 

What we are seeing are central banks in advanced countries paying for the costs of massive QE by using their balance sheets to offtake duration risk from the markets, thus alleviating pain from interest rate hikes. In February, the Bank for International Settlements drew attention to this in a paper titled “Why are central banks reporting losses? Does it matter?

Basically, when QE expanded central bank balance sheets, they started holding more long-dated Treasury paper. The Fed also owns mortgage-based paper. The Bank of Japan (BoJ) anticipated the interest rate risk and took over long-term securities from Japanese pension funds, but also ended up buying long-term US Treasuries and European sovereign debt. Thus, when interest rates are hiked, almost all advanced central banks ended up with lower profits or higher book losses.

According to the Financial Times, Fed data up to September 2022 showed unrealised losses of US$1.3 trillion on its books. Meanwhile, losses to the Bank of England and the European Central Bank were potentially US$200 billion and US$800 billion respectively. The Swiss National Bank posted a record loss of US$143 billion in 2022. Since the BoJ has not raised interest rates, the fear is that Japanese long-term bonds will suffer similar losses if interest rates are raised when inflation returns or after central bank governor Haruhiko Kuroda retires at the end of this month. 

The US headline inflation reading eased slightly in February to 6%, but remains higher than the 2% long-term target. Fed chair Jerome Powell’s signal that he was prepared to be more aggressive sent yields of two-year Treasury bonds above 5% in anticipation of the Federal Open Market Committee meeting this week. The SVB collapse flattened all expectations, so two-year yields fell to 4% by March 13. In the ensuing confusion, there is market talk that the Fed will halt its planned rate hikes. Will the Fed’s next move be to continue quantitative tightening or to pause its rate hikes? Fund managers think that with financial stability in mind, the worst of the interest rate hikes is behind us.

Video link here.

The reckoning from over a decade of QE easy money is nigh. There are no easy solutions. SVB turned the spotlight on investment losses on bank books, so higher interest rates with tighter monetary policy not only exacerbate those unrealised losses but also accelerate recessionary trends in a blow to public confidence. But if inflation continues to increase, even current nominal rates will increase the fiscal debt burden of all countries with excessive debt. 

Furthermore, we have yet to see the full costs of current losses when bank loans and mortgage funds are repriced to market. For example, US mortgage loans are often offered on 30-year fixed-rate terms, and 85% of outstanding home mortgages were financed at below 5% interest rates. A rising policy rate (Fed funds rate), which now stands at 4.75%, will increasingly pressure bank profits. There was still US$12.5 trillion mortgage debt outstanding in the US financial system at end-2022, but cheap funds are over for all.

The Fed’s unenviable task of gracefully managing inflation downwards is like walking a tightrope across the Grand Canyon — damned if you do and damned if you don’t. If the unrealised losses shake public confidence in the financial system, ultimately it erodes confidence in the US economy. James Carville, political strategist for former US president Bill Clinton said famously that he would like to be reincarnated as the bond market, since “you can intimidate everybody”. At current levels of volatility, the bond market not only risks destroying banks but also a lot of reputations around the world.

Tan Sri Andrew Sheng writes on global issues that affect investors. Tan Yi Kai is a Malaysian multi-asset trader based in Hong Kong.

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