Market View

A knife-edge decision

Looking back to the start of the month, the predominant concern for investors was just how much further central banks would increase rates in March. Given the signs of economic resilience and stickier inflation, the hawkish rhetoric was upped. All of those assumptions were brought into question by a wall of worry over the past seven days. It is easy to see why the many historical comparisons have been made given the week we have just had.

Jeremy Sterngold, Deputy Chief Investment Officer
Stacked coins with the city view in the background

On Sunday the 16th of March 2008, almost fifteen years ago to the day, the US Bank, Bear Stearns, collapsed and was sold to JP Morgan under the guidance of the Federal Reserve (Fed). Despite the Fed’s efforts to provide liquidity on the Friday that preceded it, ultimately a deal was sealed over the weekend to secure the fate of the undercapitalised bank. Does this episode sound familiar to any recent news stories?

It is understandable why so many references to the Bear Stearns episode have been made. For many, its downfall was a prelude to what was to come later that year when Lehman Brothers collapsed. Given the long-lasting and widespread impact of the financial crisis, it is easy to see how recent events have caused a great deal of anxiety. 

However, the failure of Silicon Valley Bank (SVB) was more a function of its success within the venture capital circles, poor risk management and looser regulations. These issues only came up to the boil as the Fed turned up the heat. If regulations had not been loosened in 2018, the regulator would not have allowed SVB to hold such a large portion of its cash reserves in interest sensitive holdings. The deposit swell that occurred following the pandemic and subsequent draw down meant SVB would have been forced to lock in these losses to accommodate deposit demands and subsequently would run out of capital. While SVB was the most extreme example, other banks also faced losses on their holdings of treasuries and mortgage-backed securities. Fearing a more systemic episode, investors and the public started questioning the health of other US regional banks and global banks. 

As seen many times in history, when confidence evaporates, queues start forming outside banks with depositors trying to take their money out. The convenience and speed of mobile banking means that this process is far quicker than at any point in history. These bank runs can spread like wildfire and subsequent loss of consumer confidence is difficult to measure. The question is, how well equipped is the banking system to handle these shocks and where do these recent episodes leave central banks on their quest to quell inflation?

Following the financial crisis, the Basel III accord set out a much more robust framework to regulate the banking system. It required banks to hold a lot more capital measured against the overall riskiness of their lending. It also set parameters on available liquidity to fund deposit outflows and required larger banks, to hold additional buffers. These banks are then subjected to rigorous stress tests, which assume severe recessions, to determine how well managed they are. If the stress test shows any gaps, banks would then be suspended from making distributions to shareholders. As a result, the amount of gearing in the banking system is greatly reduced and larger banks have enormous liquidity available to them. The interventions by the Fed, US Treasury and the Federal Deposit Insurance Corporation (FDIC) have given smaller banks sufficient access to liquidity to weather the storm, but it will take time to see how quickly confidence builds up in the wake of the recent news and whether the business models remain viable. As we have seen through past cycles, the banking system is likely to become more consolidated, especially given that the regulatory burden is likely to increase for the smaller banks. 

Turning the focus to central banks, the widely anticipated European Central Bank (ECB) meeting took place yesterday in the midst of the turmoil. Given the backdrop, some investors expected the ECB to deviate from its pre-announced intention to raise rates by 0.5% and opt for a smaller 0.25% increase. While the ECB stuck to their guns, the messaging around it was rather dovish. Although they referenced the high levels of core inflation that need to be quelled, in terms of future increases, they emphasised that nothing was pre-determined. Following the meeting, it was reported that the ECB feared that not going ahead with the 0.5% may increase panic and cause further concerns about the banking system. The famous idiom, “you’re damned if you do and damned if you don’t”, comes to mind. 

Next week, we have the Fed and the Bank of England announcing their latest rate decisions. The difficulty for the Fed is that given the sharp falls in confidence and in share prices of regional banks, this is likely to have a profound knock-on effect to broader financial conditions. We have touched upon the “long and variable lags” of monetary policy in a previous Brief article. Recent events are likely to have cut these lags considerably. With lending rates, activity and consumer confidence all in question, does it still make sense for the Fed to raise rates further? That is the question we, and the wider community, have been considering. Ultimately, if the market settles over the coming days, the Fed may decide that given the inflation backdrop, further, albeit modest, tightening is still appropriate. However, it could be justified in adopting a ‘wait and see’ approach or even considering cutting rates in light of recent events. 

Central banks are trying to balance price stability with financial stability, doing that while the situation is still unfolding is incredibly challenging. As such, the decisions next week have to be finely balanced. 

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