Moneycontrol Pro Panorama | The Fed puts out the forest fire… after starting it

In today’s edition of Moneycontrol Pro Panorama: US losing its influence in the middle east, India on its way to be a semiconductor major, new HUL chief has his hands full, is India ready for faster trains, and more

Manas Chakravarty

March 13, 2023 / 14:47 IST

US Federal Reserve. (File image)

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The US financial system dodged a bullet this weekend, with the Fed rushing to ensure that all depositors in the now-defunct Silicon Valley Bank will be protected. That will stem the widely expected bank runs on regional banks, as uninsured depositors scrambled for the exits. It has already calmed the markets.

Also, the Fed has announced a backstop liquidity facility, the ‘Bank Funding Term Programme’, allowing beleaguered banks to borrow from it using their bond holdings as collateral at face value, rather than their written-down market value. That is a huge relief for banks, who will no longer have to sell their security holdings at a loss to get funds.

The Fed has managed to stop the panic, but what are the signals from the entire episode?

The biggest takeaway of all, not from the depositor bailout but from SVB’s collapse, is a failure of regulation at the Fed. After keeping interest rates ultra-low and allowing excesses and distortions to build up in the financial system and lulling the markets into a false sense of comfort by insisting that the inflation risks were temporary, the Fed did a U-turn and proceeded to raise the policy rate at a very aggressive pace. Bank of America’s Michael Hartnett had warned that the pace of Fed tightening would “break something”. To be sure, the Fed has rushed in to put out the forest fire, but it could be argued that they were the ones to start the fire.
The key signal for depositors in US banks, including uninsured depositors, is that their deposits will be protected. If the depositors at SVB, the 16^thlargest US bank, have been fully protected, then the implicit assurance is that all depositors in even medium-sized banks will be protected.
For the banks, the key message is that they can keep on pretending that there have been no losses on their bond portfolios, simply because they can borrow against it at face value. There is no penalty for accessing the Fed’s discount window—funds will be available at 1-year overnight indexed swap (OIS) plus a minor 10 basis points. It is as if, as far as banks’ bond portfolios are concerned, the interest rate hikes haven’t happened at all.
Who bears the cost of bailing out the depositors? The Fed statement says, “Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.”That means well-run banks will have to bear the costs imposed by the imprudent ones. They are likely to pass on these costs to depositors.
Will the Fed decision not lead to moral hazard? It has been argued that the management and board of SVB have not been protected. That is true, but the backstop facility does indicate that banks will now be able to access funds from the Fed despite following reckless policies. If that is not moral hazard, what else is it?
Equity holders in SVB and at Signature Bank have not been spared, but for other banks, the availability of a liquidity backstop is a huge advantage, boosting confidence in banks, which should help their stocks.
The less said about rating agencies, the better. SVB went from investment grade to default overnight. But what’s new?
This bailout of depositors is unlikely to stop them moving from low-interest bank deposits to other instruments that pay more, including money market mutual funds.
Will new skeletons come out of the closet? They undoubtedly will, and SVB is probably the first among many, but these skeletons will quickly be covered up by the Fed. Where can these skeletons be found? Although the Fed’s latest Stability Report (November 2022) gave a clean chit to banks, it said, “Prime and tax-exempt money market funds (MMFs) as well as other cash-investment vehicles remain vulnerable to runs, and some of these vehicles maintain stable net asset values (NAVs) that make them particularly susceptible to sharp increases in interest rates. Some open-end bond mutual funds continued to be susceptible to large redemptions because they hold assets that can become illiquid amid stress while promising shareholders the right to redeem their shares every day.”
More broadly, the risk is this, as stated in the Fed’s Financial Stability Report: “Higher-than-expected interest rates could lead to increased volatility in financial markets, stresses to market liquidity, and declines in asset prices, including prices of both commercial and residential real estate properties. Such effects could cause losses at a range of financial intermediaries, reducing their access to capital and raising their funding costs, with further adverse consequences for asset prices, credit availability, and the economy.”
Will the Fed be cautious about raising interest rates further? That will, of course, depend on the inflation trajectory. The market now assigns a 94 percent probability of a 25 basis point hike at the Fed’s next meeting on March 22. The terminal level for the Fed Funds rate is assumed at 500-525 basis points and by December this year, the expectation is of the Fed Funds rate going back down to 475-500 bps or even lower. But the Fed’s liquidity backstop does allow it to continue to hike interest rates without wrecking the financial system.

With the Fed bailout of SVB’s depositors being the news of the day, we had two articles on it -- one on why the Fed was forced to step in and another on the fallout of SVB’s collapse on Indian start-ups.