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Issue 24: Silicon Valley Bank—The Aftermath

March 20, 2023

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Silicon Valley Bank: The Aftermath

FDIC deposit insurance limits scrapped
Just over a week ago in the wake of SVB’s unexpectedly failure, depositors at other institutions witnessed the drama unfolding and rushed to pull their money, raising fears of a wave of liquidity crises that might bring other institutions down. Two days after SVB collapsed, New York’s $100 billion crypto-focused Signature Bank was shut down, marking the third-largest bank failure in US history (SVB ranks second). Recognizing some systemic risk brewing, regulators were compelled to announce that FDIC insurance on deposits, typically restricted to a depositor’s first $250,000, would be extended to cover the full balance of anyone with money at SVB or Signature. The move effectively bailed out a staggering 94% of deposits at SVB estimated to be above the FDIC’s limit, including the balance of TV streamer Roku, which had nearly $500 million stashed in the bank.


Bailout begets a moral hazard
While the move to disregard deposit insurance limits was no doubt celebrated by tech CFOs who might have been a little lax in allocating their companies’ cash balances, not everyone was so enthused. While it’s true that the failed banks’ shareholders were not being bailed out—the owners of Silicon Valley Bank and Signature Bank will almost certainly lose everything—and although any shortfall in funds required to make depositors whole will come out of fees banks pay to the FDIC for their insurance, questions have been swirling over the last week as to how severe a “moral hazard” the rescue creates. Perhaps the biggest issue is that such backstops encourage excessive risk-taking. A depositor with millions of dollars to invest would be inclined, for example, to simply choose a bank offering the highest and riskiest yield on deposits, knowing that the FDIC would ultimately pick up the tab if the terms turned out too good to be true.


Stopping a liquidity crisis in its tracks
In our view, while the decision to disregard FDIC insurance limits unquestionably creates incentive problems, it seems to have been the lesser of two evils. The move clearly shored up confidence in America’s banking system, defusing systemic risk by arresting a growing liquidity crisis, likely preventing the imminent failure of banks like First Republic, which had an estimated 68% of its deposits above the FDIC limit, and was clearly teetering after SVB’s collapse. Indeed, we find it somewhat reassuring to examine the TED spread here, which measures the difference between the 3-month LIBOR—the rate at which banks lend to one another—and 3-month US T-bills (see below).

Figure 1 TED Spread

When banks become riskier, a larger premium is baked into interbank loans, pushing LIBOR higher and expanding the TED spread. The failures driving spikes in this spread typically result when banks’ loan books are weak and their balance sheets are hit with the implosion of complex assets. SVB’s case was quite different, representing an extreme mismatch between duration of its assets and liabilities: i.e., a liquidity problem rather than a solvency problem. That’s why today’s TED spread is far below what we saw in 2008, as the Global Financial Crisis was in full swing.

Inflation and Fed Policy

Processing last week’s CPI print
Last week saw the US Bureau of Labor Statistics (BLS) release its February 2023 CPI report, with headline inflation meeting expectations, rising by 6% year-over-year, up 0.4% from last month. Unfortunately, core CPI topped economists’ forecasts, climbing another 0.5% for the month and exceeding the prior month’s 0.4% rise. Roughly 70% of the increase in headline inflation was accounted for by housing-related costs, which shot 0.8% higher and logged their largest monthly gain since the 1980s. Services costs were also generally higher, and transport expenses surged 14.6% from the previous year. While so-called “base effects” can sometimes make year-over-year CPI numbers hard to digest—for example, we expect the CPI growth rate to decline mechanically over the next few months due to the high-water mark hit by the series a year ago—other stats leave less doubt as to the Fed’s mindset. The most recent productivity report showed a significant upward revision to compensation per hour and unit labor costs, while the Fed’s favorite measure of inflation, personal consumption expenditures (PCE) excluding housing, is not moderating at the same speed as headline CPI. Our bet is that rate cuts are still miles away.


Banking crisis prompts bets on easing
Despite our view that the Fed will maintain its restrictive policy—and despite Powell himself signaling a possible 50 bps rate hike in the days immediately prior to SVB’s downfall—traders rushed last week to make bets that the Fed would respond to the liquidity crisis by possibly pausing at its March meeting and moving to ease as early as June (see below). The shock of SVB’s failure and about-face in futures prices were so great, in fact, that market volatility triggered circuit breakers in CME Group trading on some rates futures, halting transactions for two minutes last Wednesday and forcing traders to resort to the telephone for completing deals. Later in the week, in light of a too-hot-for-comfort CPI, futures moved back to pricing in high likelihood of a 25 bps hike: our expectation all along. Ultimately, we don’t expect the Fed to waver in its determination to bring down inflation, and believe it would take something much bigger than a liquidity crisis at two poorly managed regional banks to force their hand.

Figure 2 Fed Fund Futures Curve

Fed action gradually weighing on the economy
In fact, as we alluded to last week, SVB’s collapse shows the Fed that what they’re doing is working, albeit on a long lag. Over the past decade, banks have been slow to raise their deposit rates for a number of reasons. For one thing, quantitative easing in the wake of the global financial crisis and pandemic relief checks brought a large amount of liquidity into the system, leaving banks significantly over-reserved. Because banks didn’t have too much demand for loans, the growing deposit balances were an embarrassment of riches. Moreover, the yield spread between deposit accounts and alternatives like long-term Treasuries was so low, depositors didn’t have much incentive to move. This all changed, of course, as the Fed pumped up rates beginning in early 2022. Banks monetized the shift by making higher-rate loans and postponing increases in deposit rates—accounting for US banks’ net interest income rising 20% to $633 billion in 2022. Depositors eventually took notice and since November of last year have been moving from commercial bank deposits to money market funds yielding well above 4% (see below).

Figure 3 Bank Deposits vs Market Market Fund Assets

It was precisely this sudden flight of capital—triggered by years of low rates and a fast pivot by the Fed—that created the liquidity stress which pushed SVB past the brink just over a week ago. As we’ve noted in prior Perspectives, we’re in the early innings with respect to effects of last year’s Fed tightening on the real economy, and with inflation yet to show meaningful cooling, we see more pain in store for risk assets and just as much reason as ever for a defensive footing.