by Chris Black
This article from the Economist (archive.is/d2nxa) gives the best summary of the banking crisis I’ve seen so far for those of you struggling to wrap your heads around it.
Basically the Federal Reserve has put in place a financial asset buyback program to prevent any more US banks from collapsing SVB style by buying back assets at inflated prices despite their market price collapsing in recent months.
This would allow banks to deposit high-quality assets, like Treasuries or mortgage bonds backed by government agencies, in return for a cash advance worth the face value of the asset, rather than its market value. Banks that had loaded up on bonds which had fallen in price would thus be protected from SVB’s fate. The Fed and Treasury’s interventions were the sort which would be expected in a crisis. They have fundamentally reshaped America’s financial architecture. Yet at first glance the problem appeared to be poor risk management at a single bank. “Either this was an indefensible overreaction, or there is much more rot in the American banking system than those of us on the outside of confidential supervisory information can even know,” says Peter Conti-Brown, a financial historian at the University of Pennsylvania.
The article explains that research suggests the US banking system’s assets have a market value about $2 Trillion less than their “face value,” and that if half the currently uninsured deposits in the US banking system were withdrawn the total assets held by the entire US banking system wouldn’t be enough to cover them.
The newfound ability to swap assets at face value, under the Bank Term Funding Programme, at least makes it easier for banks to pay out depositors. But even this is only a temporary solution. For the Fed’s new facility is something of a confidence trick itself. The programme will prop up struggling banks only so long as depositors think it will. Borrowing through the facility is done at market rates of around 4.5%. This means that if the interest income a bank earns on its assets is below that—and its low-cost deposits leave—the institution will simply die a slow death from quarterly net-interest income losses, rather than a quick one brought about by a bank run.
So basically the Fed has put a mechanism in place which will simply slow down the crisis rather than solve it.
This is why Larry Fink, boss of BlackRock, a big asset-management firm, has warned of a “slow-rolling crisis”. He expects this to involve “more seizures and shutdowns”. That high interest rates have exposed the kind of asset-liability mismatch that felled SVB is, he reckons, a “price we’re paying for decades of easy money”.
Interest rates were jacked up to slow down the inflation unleashed by the covid stimulus expanding the money supply at record rates, so the Federal Reserve feels unable to reduce them again to re-inflate asset prices. And if they were to reduce interest rates it would reinforce the impression that we are in a financial crisis and undermine the ‘confidence trick’ the Fed is trying to pull here. Basically the Fed is between a rock and a hard place and trying to buy itself time, but this might be a crisis to which there is no solution in the final analysis.
Mr Conti-Brown of UPenn points out that there are historical parallels, the most obvious being the bank casualties that mounted in the 1980s as Paul Volcker, the Fed’s chairman at the time, raised rates. Higher rates have exposed problems in bond portfolios first, as markets show in real-time how these assets fall in value when rates rise. But bonds are not the only assets that carry risk when policy changes. “The difference between interest-rate risk and credit risk can be quite subtle,” notes Mr Conti-Brown, as rising rates will eventually put pressure on borrowers, too. In the 1980s the first banks to fail were those where asset values fell with rising rates—but the crisis also exposed bad assets within America’s “thrifts”, specialist consumer banks, in the end. Thus pessimists worry banks now failing because of higher rates are just the first domino to collapse.
So yeah, even if crisis has been averted this week, it looks like a global recession is inevitable.