Insight | March 27, 2023
Muzinich Weekly Market Comment
Weekly Update – Confidence Part 2
A bank run can be defined as a single bank problem, resolved through nationalization or a merger into a stronger entity, as has happened in Europe over a recent weekend. A banking crisis occurs when many financial institutions face the same problem at the same time. Under this category, it is important to understand whether the common problem is caused by exposure to toxic assets, as was the case for both the Global Financial Crisis in 2008 and the Latin Debt Crisis in 1992. If this is the case, the only solution is for governments to inject capital, a “bail out.” This is politically unpopular, as the banks are saved at the expense of taxpayers and ultimately the regulator must take the responsibility for oversight complacency. The other form of banking crisis occurs when assets are robust, but mark-to-market problems generate insolvency. This was the case for the Savings and Loan (S&L) Crisis in 1979; nearly all mortgages at the time were 30-year fixed-rate products and the typical mortgage rate was around 7% vs. short-term funds costs that increased to 22% as former Chair of the Federal Reserve (Fed) Paul Volcker stamped out inflation.
In our view, the current US regional bank crisis is in this latter category; assets are robust, mostly AAA rated US government securities, but deposit outflows are forcing the crystallization of mark-to market losses, leading to insolvency. When the asset base is robust, capital injections are not necessary; authorities need to announce supportive temporary regulation to shield bank balance sheets and boost depositors’ confidence. For the S&L crisis, the US authorities issued certificates of solvency to the banks. While in the current crisis, the Fed has opened a repo facility that allows banks to raise liquidity without incurring mark-to-market losses. This just leaves the confidence boost. As Citigroup CEO Jane Fraser explained this past week, mobile apps and the ability of consumers to move millions of dollars with a few clicks of a button, mark a sea change for how bankers manage—and regulators respond to—the risk of bank runs. Consequently, this week the authorities had one objective: boost confidence.
First came statements from both the European Banking Authority (EBA) and the Bank of England (BoE) declaring that common equity instruments would be first to absorb losses. This was in response to the Swiss authorities, who had surprised investors by allowing the write down of AT1 debt ahead of common equity as part of the UBS merger with Credit Suisse First Boston (CSFB). Next, it was the Federal Open Market Committee’s (FOMC) turn; the FOMC followed the exact script that was successful for the European Central Bank (ECB) the previous week. The FOMC hiked 25 basis points (bps) to the range of 4.75% - 5.00% with no change to its balance sheet program. The FOMC also removed its commitment to further interest rate increases, stating that some more policy tightening may be warranted, but they are now data dependent. With their next meeting not until May 2nd, they have time to better evaluate how contained the banking sector issue will be and the knock-on effect into the economy. They will also have time to further monitor the lagged effects of policy tightening to date on inflation and employment. The Committee published its quarterly economic forecasts (see Chart of the Week). Relative to December 2022, projections for 2023 have been adjusted down by 0.1% for growth and employment (to 0.4% and 4.5% respectively), and Core Personal Consumption Expenditures (PCE) inflation has been increased by 0.1% to 3.6%. The standout talking point from the projections is that the FOMC expects to stay restrictive at a median yield of 5.1% for the whole of 2023, with loosening not projected until 2024. Meanwhile investors seem to be taking a much more pessimistic view on the banking sector stress, with expectations for loosening to start in June 2023.
Unfortunately, the positive sentiment built by the FOMC was knocked down by Treasury Secretary Janet Yellen. During a hearing before a senate subcommittee, Yellen said “I have not considered or discussed anything having to do with blanket insurance or guarantee of deposits,” in answering a question about whether the protection for all US deposits would require congressional approval.1 Yellen did reverse this stance the next day, noting that the regulator is prepared for addition deposit action if needed, however, the damage was done. On a positive note, from the weekly Fed balance sheet release, the Fed’s outstanding loans only increased US$37bn.2 This increase was due to new loans to the Federal Deposit Insurance Corporation (FDIC) managed banks. This suggests that over the past week US banks have been able to manage any deposit outflows without sourcing new Fed liquidity.
Chart of the Week: FOMC Still Not Projecting Rate Cuts for 2023
Source: Federal Open Market Committee (FOMC) Summary of Economic Projections, 22nd March 2023
1.Reuters, “Yellen says not considering ‘blanket insurance’ for all US bank deposits,” 22nd March 2023
2.Federal Reserve Statistical Release, 23rd March 2023
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