Raghuram G. Rajan and Viral V. Acharya,
CHICAGO – The recent bank collapses in the United States seem to have an obvious cause. Ninety percent of deposits at Silicon Valley Bank (SVB) and Signature Bank were uninsured, and uninsured deposits are understandably prone to runs.
In addition, both banks had invested significant amounts in long-term bonds, the market value of which fell as interest rates rose.
When SVB sold part of these bonds to raise funds, the unrealized losses in its bond portfolio came to light. A botched share offering then triggered the run on deposits that sealed its fate.
But four elements of this simple explanation suggest that the problem may be more systemic. First, there is typically a huge increase in uninsured bank deposits when the US Federal Reserve applies quantitative easing.
Because it involves buying securities from the market in exchange for the central bank’s own liquid reserves (a form of cash), QE not only increases the size of the central bank’s balance sheet, but also of the balance sheet of the wider banking system. and are uninsured demand deposits.
We (along with co-authors) drew attention to this underappreciated fact in a paper presented at the Fed’s annual Jackson Hole conference in August 2022.
As the Fed resumed QE during the pandemic, uninsured bank deposits rose from about $5.5 trillion at the end of 2019 to more than $8 trillion in the first quarter of 2022.
At SVB, deposit inflows increased from less than $5 billion in the third quarter of 2019 to an average of $14 billion per quarter during QE. But when the Fed ended QE, raised interest rates and quickly moved to quantitative tightening (QT), these flows reversed.
SVB began to see an increase in uninsured deposit outflows (some of which coincided with the downturn in the tech sector, as the bank’s stressed clients began withdrawing cash reserves).
Second, many banks, which had benefited from the deluge of deposits, bought liquid longer-term securities, such as government bonds and mortgage-backed securities, to generate a profitable “carry”: an interest rate spread that yielded returns in excess of what the banks had to pay on deposits.
Normally this would not be so risky. Long-term interest rates had not risen much for a long time; and even if they did start to rise, bankers understand that savers are often sleepy and will accept low deposit rates for a long time even when market interest rates rise. So the banks felt protected by both history and depositor complacency.
Yet this time it was different as these were volatile uninsured deposits. Because they were generated by Fed action, they were always ready to flow if the Fed changed course.
And because major depositors can easily coordinate with each other, actions by just a few can trigger a cascade.
Even in healthy banks, savers who have become aware of banking risk and the healthier interest rates available with money market funds will want to be compensated with higher interest rates.
The juicy interest rate differentials between investments and dormant deposits will be threatened, affecting banks’ profitability and solvency. As an apt saying in the financial industry goes, “The road to hell is paved with positive carry.”
The third concern is that these first two elements are magnified today. The last time the Fed moved to QT and rate hikes, in 2017-19, the hike in policy rates was less sudden and significant, and the volume of interest-rate sensitive securities held by banks was smaller.
Consequently, the losses for bank balance sheets to absorb were small and there were no deposits, although many of the same ingredients were present.
This time around, the magnitude of interest rate hikes, their speed, and banks’ holdings of interest-rate sensitive assets are all much larger, with the Federal Deposit Insurance Corporation suggesting that losses on available-for-sale and held-to-maturity bank securities holdings alone could exceed $1. could amount to 5 trillion.
The fourth concern is ignorant oversight coordination with industry. Clearly, too many regulators failed to see banks’ rising interest rate exposure, or were unable to force banks to reduce it.
Had supervision been tighter (we’re still trying to gauge how far it fell), fewer banks would have been in trouble by now.
Another problem, however, is that regulators have not checked all banks in the same way as the largest institutions (which have been subjected to stress tests, among other things).
These differential standards may have led to a migration of high-risk commercial real estate lending (think all those half-empty office buildings during the pandemic) from larger, better capitalized banks to relatively weakly capitalized small and mid-sized banks.
As a result, while many vulnerabilities in the banking system have been created by bankers themselves, the Fed has also contributed to the problem.
Intermittent periods of quantitative easing have expanded and cluttered banks’ balance sheets with more uninsured deposits, making banks increasingly dependent on easy liquidity.
This dependency makes it more difficult to reverse QE and tighten monetary policy. The larger the magnitude of QE and the longer its duration, the more time the Fed should take to normalize its balance sheet and, ideally, raise interest rates.
Unfortunately, these concerns about financial stability conflict with the Fed’s anti-inflation mandate. Markets now expect the Fed to cut rates at a time when inflation is significantly above target, and some observers are calling for QT to be halted.
The Fed is again providing large amounts of liquidity through its discount counter and other channels. If the problems in the financial sector do not slow down the economy, such actions could prolong the fight against inflation and make it more expensive.
The bottom line is that the Fed is re-examining bank behavior and supervision and cannot afford to ignore the role its own monetary policy (especially QE) has played in creating the current difficult environment.
Raghuram G. Rajan, former governor of the Reserve Bank of India, is a professor of finance at the University of Chicago Booth School of Business and most recently the author of The third pillar: how markets and the state leave the community behind (Penguin, 2020). Viral V. Acharya, former deputy governor of the Reserve Bank of India, is a professor of economics at New York University’s Stern School of Business.
Copyright: Project Syndicate, 2023.www.project-syndicate.org
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