To be hawkish, or not to be hawkish is the Fed dilemma

Just about two weeks back, the Fed had a simple mandate. Recovery in growth was happening at a slow pace, Inflation remained elevated and strong employments levels were ensuring that consumer spending took longer to response to higher rates. In a matter of one week, the narrative has entirely changed. With the fall of SVB Financial and a slew of others following, the latest challenge for the Fed is to keep the banking system robust and functioning. Will this change the tone of the Fed from too much hawkishness to moderate hawkishness? We will come back to that later.

How SVB Financial went bust?

When SVB Financial folded up last week, two apparent reasons were seen for the collapse. The first was its huge exposure to the Silicon Valley start-ups. Nearly every third start-up and venture capital financier had a banking relationship with SVB. In the last one year, there has been a funding winter for start-ups (especially digital start-ups). This led to a cash crunch, forcing these start-ups to withdraw close to $41 billion from their deposits. That was unexpected and to pay these deposits SVB had to heavily resort to selling its bonds. Therein came the second problem. When deposits are demanded, it has to be a fire-sale of bonds. In the last 1 year, Fed rates are up 450 bps so bond portfolios are sitting on huge losses. In the case of SVB, due to the fire-sale, they had to book $1.8 billion loss and that hole did them in.

But things at SVB are not as simple as it appeared at first glance. It is increasingly becoming evident that much of what happened at SVB had to do with its own asset quality, internal policies and risk management. Clearly, SVB had fallen short on all these fronts. Here is some classic evidence.

• SVB had adopted the compromise of business growth at the cost of compliance. To encourage the flow of start-up business, SVB had relaxed most compliance guidelines. For instance, the bank allowed start-ups to open a bank account even without a social security number. 

   

• SVB did not comply with the FDIC insurance limits. Currently, the Federal Deposit Insurance Corporation only allows deposits to the tune of $250,000. However, in the case of SVB, there were more than 37,000 mid-sized start-ups with deposits above this FDIC imposed limit of $250,000. 

   

• The result was that out of the total deposit base of nearly $175 billion that SVB had, nearly 90% of the deposits were not covered by the deposit insurance offered by the FDIC. This made depositing money with SVB extremely risky, but deposits did not mind.

   

• All the Y-Combinator backed start-ups globally had an exposure to SVB, either in the form of deposits or loans or equity investments. This meant that the start-ups would be the worst hit in the event of any collapse of SVB Financial, which is what happened. 

All these factors gave SVB a unique edge over traditional banks in attracting start-up deposits. But it also exposed the banks and the depositors to undue risk.

Will Fed remain stoic after 3 bank failures?

In a matter of one week, 3 US banks went bust. Of these SVB Financial had a deposit base of $212 billion, Silvergate Capital had a small deposit base of $15 billion while Signature Bank had a deposit base of about $90 billion. The Fed swung into action when First Republic Bank with assets of $197 billion started sinking. That is when it syndicated a rescue plan with JP Morgan and Morgan Stanley infusing close to $30 billion as deposits into First Republic Bank. Then there was the special window for banks to borrow from the Fed.

Here is how the special window BTFP (Bank Term Funding Program) will work. Most banks in the US hold deposits backed by investments in government bonds. The problem is that 450 bps rate hike by the Fed would have substantially eroded the value of these bonds. That was the trigger for the collapse of SVB. It is estimated that the US banks, as a whole, had $650-$700 billion of potential bond losses in their books. That means any sale would mean booking losses and any funding would mean lower limits. To overcome these problems, the US Fed has started a special window wherein banks and financial institutions can borrow from the window by offering their bond holdings as collateral. The best part is that the funding will be done on the original value and not at the depreciated value due to bond losses.

That would mean a lot of liquidity infusion, but there is not much of a choice that the Fed has at this point. If the run-on banks continue, the potential bond losses would become actual losses causing huge losses to the banks and to the depositors. 

Will the US Fed go slow on rate hikes now?

Just a week back, the narrative was about moving quicker on rate hikes to fight inflation and strong labour data. Have things really changed in the last one week? Will the Fed start to reconsider its hawkish stance? For now, it looks like the Fed is keeping its hawkishness and liquidity separate. According to the Fed, the problems with banks like Signature Bank and SVB are more specific to the models adopted by such banks. However, that cannot be blamed on the Fed hawkishness alone because there are scores of other banks that are still sound. Yes, bond depreciation losses could be a challenge but that is what the BTFP (Bank Term Funding Program) of the Fed will address. The moral of the story is that the Fed intends to keep its hawkish monetary stance and its liquidity support to banks separate. It is unlikely to change the stance of the Fed for the time being. Hawkishness stays on.

Christine Lagarde suggested something similar

Similar statements were also made by Christine Lagarde, head of the ECB, after the 16th March meeting once again hiked rates by 50 basis points. In her post statement interview, Lagarde drew a fine line of distinction between inflation risk and financial risk and promised to keep the two separate. That is why, when Credit Suisse showed signs of stress, the Swiss National Bank agreed to give the bank funding to the tune of $54 billion. However, at the same time, the ECB also hiked the rates by a full 50 bps indicating that the ECB would continue to work to contain inflation as well as inflation expectations. So, neither the Fed, nor the ECB is giving up its hawkish monetary stance for now. However, it remains to be seen whether these central banks can maintain this stoicism, if the banking crisis worsens.

What does the RBI do now?

For now, the situation in India is well under control. Indian banks are not globally exposed like the US and European banks, so the RBI should have less of a problem. Also, Indian banking is largely domesticated so global forces will have less of an impact. That means the RBI can also afford to run a hawkish rate policy and a more lenient liquidity policy. In the event of any crisis, the RBI is also likely to rely more on liquidity management without changing its hawkish stance. But the bigger takeaway for the RBI and the Indian government is that it puts to rest the dilemma of financial risk versus inflation risk. For now, risk of contagion looks limited in India and any fallout of the SVB crisis can be manage through liquidity infusion alone. Battle against inflation via rate hikes is here to stay.