This Week’s Note
march 17, 2023
This Week in the US Financial System
Shortly after trading began on March 10, 2023, shares of Silicon Valley Bank (“SVB”, NASDAQ: SIVB) were halted as the share price dropped 68% premarket to $34 on heavy volume. By midday, regulators took the bank into receivership under the FDIC, and SVB—the 16th largest US bank—became the largest bank crash since 2008. Across the country, Signature Bank saw customers pulling substantial amounts of deposits from its holdings, and on March 12 regulators took control of the bank to stop a banking contagion.
In the week since, the US financial system has seen a meaningful amount of volatility, particularly in mid-tier and regional banks. For example, First Republic Bank, after being downgraded by both S&P and Fitch, receiving an injection of uninsured cash deposits from lending competitors and appears to have avoided a liquidity crunch for the time being. Other banks face downgrades as well, such as Western Alliance Bancorporation and PacWest Bancorp after being placed on Rating Watch Negative by Fitch at BBB-.
Beyond a select handful of banks on watchlists, conditions are evolving in pockets of the US financial system. There is a potential signal of systemic distress in the activity at the Federal Reserve’s Discount Window, which, in the reporting week ending March 16, lent out approximately $153 billion in the last week to eligible US depository institutions (the prior high was approximately $111 million in 2008, see accompanying visual). In effect, this facility is being used for its intended purpose, described by the Fed as “providing ready access to funding, the discount window helps depository institutions manage their liquidity risks efficiently and avoid actions that have negative consequences for their customers, such as withdrawing credit during times of market stress.” However, the record-high draws against the lender of last resort suggests there is considerable strain on the system.
As the US banking sector comes to terms with the twin collapse of SVB and Signature Bank, as well as the subsequent market stress, we see a confluence of factors tilting risk to the downside. We anticipate the need for caution ahead as central banks appear to remain committed to the policy mandates, confirmed in part this week by the ECB sticking to its promised 50 basis point hike at their March 16 meeting. We anticipate that the Fed is likely to continue increasing its policy rate at its meeting next week, and it is going to take a while before we can feel terra firma as opposed to the shifting sands of untethered monetary policy.
Causes, Catalysts, and Consequences
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Tech sector and crypto exposure – SVB’s primary business focused on financing technology-related startups, which had seen venture capital raising decline meaningfully during the last twelve months, resulting in a broad-based need to withdraw cash from deposits held at SVB. Signature Bank had significant Crypto exposure, and a run-on-deposits contagion occurred shortly after news broke on SVB’s, which was likely amplified due to Signature’s high proportion of uninsured deposits (see accompanying visual).
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Fed’s rapid interest rate hike – As Fed began raising rates, mark-to-market (“MTM”) losses compensating for balance sheet liquidity left (and could leave more) banks vulnerable to covering liabilities.
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Loosening standards in 2018 for mid-tier banks/regional banks – Through 2018 US legislative action, stress-test regulations for mid-sized banks became less stringent. While there is a lack of consensus on the implications of deregulation, perspectives fall somewhere in between: (1) the rollback of the stress-tests left the mid-tier banks more vulnerable to adverse economic conditions due to structurally unsound lack of oversight and (2) no stress tests could fully capture the MTM losses from banks’ AFS holdings of long-duration Treasuries and securities.
Banks’s real estate holdings and the implications on lending
We do not anticipate immediate repercussions from recent bank collapses on the commercial real estate sector as the direct effects are, in our view, limited in scope due to SVB and Signature Bank’s relative overexposure to the technology industry and cryptocurrency positions, respectively. However, the implications of overtightening monetary policy, and the rising inter-bank competition for customers seeking higher rates on savings accounts, may create unexpected pressures on smaller regional banks if deposits shift suddenly. To the extent that these smaller banks have meaningful exposure to US commercial real estate, we could anticipate seeing pockets of distress or dislocation due to the potential continuation of tightening US monetary policy. What is unknown at this point, and perhaps more consequential to commercial real estate, is the uncertainty with regard to retraction of lending activities, especially among mid-tier and regional banks that are seeking to preserve liquidity in these turbulent times.
The market volatility following the collapse of SVG and Signature Bank, as well as the health of the banking sector, are likely to weigh heavily into the Fed’s rate decision next week. However, we do not expect a pivot or a pause despite both inflation and labor market cooling slightly in their most recent readings.
Credit Suisse: Implications for a Legacy Institution under Long-term Stress
Regarding the contagion effects of US banking failures, a consensus view might suggest more limits to risk in the European banking system. The regulatory framework and diversified nature of European banks, coupled with regular bank stress tests conducted by the ECB and European Banking Authority (“EBA”), should increase confidence in the stability of Eurozone banking institutions.
Pertaining specifically to SVB’s potential contagion effects, both the UK and Germany, which are home to two European SVB branch locations, quickly took action and swiftly averted risks earlier this week. On Monday, HSBC, Europe’s largest bank acquired the UK SVB branch and its £6.7 billion deposit balance, which should be seen as a move that helped avoid negative impacts broadly on UK tech companies while also ensuring continued smooth function of financial market operations. Similarly, the German financial regulator BaFin ceased SVB lending activity and client business through an imposed moratorium.
Yet, despite being well-capitalized and highly regulated, Eurozone banks shares dropped by close to 10% over the course of two days following the collapse of SVB and Signature bank, promulgated by the downward trajectory of Switzerland’s second largest bank, Credit Suisse. Multiple compliance failures in the last years have ushered in a sense of distrust on the behalf of Credit Suisse customers, and at the end of 2022 client outflows reached over 120 billion Swiss francs resulting in financial statements showing an annual net loss of 7.3 billion Swiss francs, their largest loss since the recession in 2008 and equivalent to $USD 7.9 billion.
On Wednesday Credit Suisse stock fell, and the cost of credit default swaps on the bank’s bonds rose drastically following the announced discovery of material weaknesses in previous years’ financial reporting processes coupled with a decision by the Saudi National Bank stating their inability to inject additional liquidity beyond their current 9.88% ownership stake of the bank due to regulatory restrictions. The Swiss National Bank has extended a $54 billion loan offer, which brought relief for the time being as of March 16.
The Credit Suisse crisis has already had and may continue to pose negative implications on the broader market. Following the bank’s stock drop, the European banking index SX7P fell 7%, which may contribute to systemic stress in the Eurozone. Potential signals of secular impacts include French banks BNP Paribas and Société Générale and German banks Commerzbank and Deutsche Bank, which all fell 8%-10% in stock value following the recent Credit Suisse developments. The decrease in stock valuations across several banks has been followed by implications in other sectors as the pan-European STOXX 600 Index, after reaching a 2023 high, fell by 3% coming into the end of this week.
The Credit Suisse crisis may not be systemic, but continued rate hikes elevated the concern regarding the fate of smaller potentially under-capitalized Eurozone banks, similar to the banking concerns in the US.
Market Rates, Catalytic Indicators, and the Week Ahead
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