Larry Fink on the possible second, third domino in US banking and financial system

The Cambridge University Dictionary defines the domino effect as a situation in which one event causes a series of related events, one following the other. Though one can find domino effects in all walks of life, perhaps the most painful could be when it happens in an economy.

Laurence Douglas Fink, or Larry Fink as he is popularly known, the chairman and CEO of Blackrock, the multinational investment company, believes the recent collapse of three regional banks in the US is part of one such domino effect being observed in the economy.

Since the 2008 financial crisis, most major markets in the world have seen easy money being available to borrowers, which led to inflation shooting higher than the historical average. Now, to tame this inflation, central banks have been forced to raise interest rates at an accelerated pace.

“The Federal Reserve in the past year has raised rates nearly 500 basis points,” said Fink, in his letter to shareholders. “This is one price we’re already paying for years of easy money—and was the first domino to drop.”

There have been several fallouts of the sharp rise in interest rates. Equities have tumbled, mortgage loans have become expensive and the most recent outcome was the collapse of the three large regional banks in the US, the biggest such event since 2008.

The second domino

Silicon Valley Bank (SVB), which was preferred by startups to park fund, saw a run following the disclosure that it had to raise a large sum of money to survive in the wake of bad choices it made while investing money—a classic asset-liability mismatch, according to Fink.

Also read: A blow-by-blow account of how and why SVB collapsed

Banks usually assume that not all depositors will withdraw their money at the same time. Hence, they don’t keep all of the depositors’ money in their reserves. In normal times, it is a pretty safe assumption. However, these are not normal times. In the case of SVB, customers started withdrawing their deposits beyond what the bank could pay using its cash reserves, also known as a run on the bank.

This was followed by two smaller banks that failed in the past week as well— Silvergate Capital Corp and Signature Bank, inducing the fear that this was the start of a rerun of 2008 (which, as is known, started with the collapse of another banking entity).

“It’s too early to know how widespread the damage is,” said Fink. “The regulatory response has so far been swift, and decisive actions have helped stave off contagion risks. But markets remain on edge. Will asset-liability mismatches be the second domino to fall?”

The answer to Fink’s question is in posterity. But the past shows that monetary tightening has more often than not exposed cracks in the financial system, said the top honcho at the largest institutional investor in the world.

He cited the example of the savings and loan (S&L) crisis that unfolded throughout the 1980s and early 1990s, or the bankruptcy of Orange County, California, in 1994—both of which were the result of the US Fed’s aggressive rate hikes.

“We don’t know yet whether the consequences of easy money and regulatory changes will cascade throughout the US regional banking sector (akin to the S&L Crisis) with more seizures and shutdowns coming,” said Fink, adding that it does seem inevitable that some banks will now need to pull back on lending to shore up their balance sheets, and that we’re likely to see stricter capital standards for banks.

The third domino?

The cascading effect of the two dominoes falling will be huge, according to Fink. He believes the third domino to fall will be liquidity mismatches, referring to those investors who have used borrowings to fund illiquid investments.

“Years of lower rates had the effect of driving some asset owners to increase their commitments to illiquid investments—trading lower liquidity for higher returns,” said Fink. “There’s a risk now of a liquidity mismatch for these asset owners, especially those with leveraged portfolios.”