For the Federal Reserve, credibility is everything. And its credibility is being tested by how it plans to manage the banking system in the days leading up to its March 21-22 meeting.
Last month, Fed Chair Powell confidently told Wall Street to prepare for a 25-basis point increase in short-term rates in March. But with inflation remaining hot, some speculators have been calling for a 50-basis point bump.
To complicate matters further, 2022's rapid rise in interest rates appears to be a stressor on the banking system. The Federal Deposit Insurance Corporation (FDIC), in recent days, took control of both Silicon Valley Bank (SVB) and Signature Bank (SB). And now some are suggesting that the Fed should pause its strategy to manage inflation with higher interest rates to help the banking system.
In short, the Fed is at a bit of a credibility crossroads. Supervising and regulating the banking system as a means of protecting consumers is one of the Fed’s most important roles. That's why the U.S. government has already approved plans to safeguard depositors and financial institutions affected by the closing of both SVB and SB.
At the same time, Wall Street wants to believe the Fed is data-dependent, not data-reactive. The markets want to believe the Fed has a plan for inflation and is considering how higher short-term interest rates are affecting the nation’s banks.
So it’s best to prepare for more market volatility in the days leading up to the Fed’s two-day meeting. Wall Street is sorting through several issues, and it’s looking to the Fed to provide some reassuring guidance.
Looking at the Silicon Valley Bank Collapse and what's next
The closure and wind-down of Silicon Valley Bank (ticker: SIVB) has led to some considerable stress in equity markets, particularly among shares of regional banks, as well as fear of contagion. While we are likely not fully “out of the woods” yet, we view the regulatory response as appropriate and likely adequate, which should head off contagion fears. There are unique elements to SVB that contributed to its demise, including its client base and risk controls.
Put simply, FDIC took over these troubled financial institutions, with the intention to create the best outcome for bank depositors. The SVB/Signature story has a lot of moving parts, but ultimately boils down to an old-fashioned bank run. A flood of withdrawals from depositors destroyed these banks.
How could this happen
Ultimately this type of situation, while complex-sounding, is fairly simple: there were not enough cash and liquid assets available that could be sold to fund deposit outflows, without wiping out their equity capital base. That’s in part because banks are not forced to carry enough cash to fund 100% of their deposits. According to regulations, they’re allowed to invest multiple dollars (think $10, in round numbers) for every dollar of deposits.
These investments, which could be in the form of loans to customers or invested in marketable securities such as US Treasuries or Mortgage-Backed Securities (MBSs), are generally longer-term in nature, and are not always able to be sold or otherwise harvested at a profit.
Comparisons have been made to gym memberships; if every gym member showed up at the same time, not everybody can get a workout in. Banks are similar in this respect, if every depositor wants their money back at the same time, not everyone can get their money back.
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