Recapping the March 2023 US banking crisis, one year later

16 Feb 2024 , 01:29 PM

One year since the US banking crisis

In March 2023, the US economy came up against a surprisingly brief, yet virulent banking crisis. It all began with the Silicon Valley Bank caught with huge losses on its investment portfolio and a run on deposits. There were two factors that were a direct outcome of the string of rate hikes undertaken by the US Fed to tame inflation. Firstly, it resulted in a liquidity crisis in the economy, so the smaller and mid-sized regional banks did not have easy access to funds. Secondly, the spike in interest rates meant that the investment bond portfolios of the banks had huge book losses. When the crisis struck Silicon Valley Bank in early 2023, liquidity tightened so the bank was unable to get funds. 

Additionally, when the news of investment losses came out, it triggered a run on deposits. The result was the collapse of Silicon Valley Bank. That was soon followed by the fall of Signature Bank and First Republican Bank. All the three were mid-sized banks, but had assets big enough to trigger a systemic crisis. However, the Fed intervened on time, bailed out the struggling banks, gave an unconditional guarantee on deposits to the deposit holders and opened the liquidity taps. The crisis was averted; but one year later, it is time to look back at how the brief crisis of March 2023 had a deep impact on the banking story in the US and around the world. This briefly spread to Europe too, with Credit Suisse First Boston going bust and merged with UBS. However, that was the worst of the crisis.

Focus of Fed policy in the last two years

It is in this context that the lectured delivered by Fed Vice Chair, Michael Barr, on “Intersection of Monetary Policy, Market Functioning, and Liquidity Risk Management” becomes extremely relevant in the current context. Speaking at the National Association for Business Economics (NABE) conference in Washington DC, Barr underlined a bird’s eye view of how the crisis had evolved and how the US monetary policy had evolved before and after the crisis. Let us first look at how the US Fed monetary policy evolved before and after the March 2023 US banking crisis and then move on to the actual crisis of March 2023 and the key takeaways for investors, analysts, bankers and for policymakers.

How monetary policy evolved; before and after the crisis

It would be appropriate to say that the bank crisis of March 2023 did take most of the policy makers by surprise. Here is a quick view on the gist of the monetary policy around the time the banking crisis evolved, and after that.

1. At the start of 2023, the standard prediction was that monetary policy would get tighter to keep inflation in check and deliberately slow economic activity. However, the March 2023 banking stress raised the spectre of a potential credit contraction risk that could substantially weaken the economy. Hence from March 2023 onwards, it was clearly a trade-off for the Fed between containing inflation and handling the banking crisis.

    

2. In retrospect, two things happened. The crisis did not worsen much due to the timely action by the Fed. Also, the much feared hard landing did not happen. The Fed managed to hold interest rates at elevated levels for longer. Year 2023 was much slower on rate hikes, compared to 2022 and that helped balance inflation and growth concerns.

    

3. As Barr admitted, the Fed had a problem interpreting the nature and intensity of inflation, which explains why it was late to start hiking rates. The inflation monster was visible from the last quarter of 2021, but the Fed hikes rates only from March 2022. Post the pandemic, the liquidity infusion resulted in a rapid revival in demand, but supply struggled to keep pace. This created supply chain bottlenecks, which led to a spike in inflation. The Fed continued to believe that inflation would be temporary, but it turned much more intense and virulent than expected.

    

4. There were several other factors that worsened the supply chain crisis. China kept its economy locked for much longer than expected. This created a problem, as China was at the core of the global supply chain. In early 2023, the Russian invasion of Ukraine led to an unprecedented spike in oil prices, which kept inflation at elevated levels. 

    

5. The US economy was long known for its relatively lower levels of productivity compared to many other countries. However, post the pandemic, there has been a perceptible improvement in the productivity levels in the US economy. This has been triggered by a number of factors like the integration of new technologies like AI/ML, new ways of working, and the large increases in new business formations. New age businesses have been known to add substantially to productivity gains and that was evident in the current scenario also. To an extent, such increases in productivity are consistent with real wage gains, which ensured that growth continued to be robust even as upward pressure on inflation diminished. 

With this background, let us move to the specific US banking crisis of March 2023.

Banking crisis – Separating the news from the noise

We have earlier seen how the banking crisis of March 2023 came about in the US and how it was handled by the Fed. However, it did have an impact on the liquidity conditions and also left the market with some important lessons from the banking crisis. The idea is to look at how to better assess the banking stress in terms of liquidity risk management, and use these readings to create a more resilient banking system. However, the Fed has cautioned that even a year after getting over the banking crisis, some risk factors like exposure to commercial real estate continue to remain a potent risk factors. 

However, the bigger challenge, according to Michel Barr, Vice Chair of the Federal Reserve is that the markets and the regulators need to separate the news from the noise. In an extremely interconnected world, some of the risks have the tendency to magnified out of shape and much more than warranted. For example, commercial real estate is a risk, but it is not exactly a show stopper, and nowhere remotely close to the sub-prime crisis of 2007. Barr has cited the example of how recently a case of a bank missing its estimates due to higher provisions led to a large scale sell-off in banks across the board. It is this kind of knee jerk reactions that detract from the core issue and unnecessarily magnify issues.

Lessons to be gleaned from the March 2023 US banking crisis

In his speech, Michael Barr has taken a retrospective view of banking crisis. The first lesson was that effective liquidity management cannot be left to regulation, but must happen at the bank level. In the case of Silicon Valley Bank, the run on deposits magnified very fast and the management had no back-up redundancy plan in place. In the case of SVB, it saw a flight of $40 Billion in deposits in a single day and expected to lose another $100 Billion the next day. There was no way the bank could have handled 85% flight of deposits. A similar story had played out in the case of Signature Bank and First Republic Bank also. In all these cases, there was no back-up liquidity plan at all.

According to Barr, the common thread in these 3 banks was the imprudent funding and the substantial reliance on uninsured deposits. Also, the deposits were concentrated in few wholesale hands and with similar needs. In the case of SVBs, the depositors were all start-ups or VCs / PE Funds; all part of the same ecosystem. In the case of Signature Bank, they had billions of dollars in uninsured depositors from crypto-related firms, where money flies at the first sign of stress. Lastly, in the case of the First Republic, the deposit base was entirely concentrated in high-net-worth investors relying on uninsured deposits. When the depositor base is so concentrated, liquidity coverage ratios hardly work in practice.

The high quality liquid assets (HQLA) are supposed to be exactly that. They must be held in high equality bonds and must be highly liquid. The problem was that many of these HQLA assets had longer durations. That meant; the moment the Fed started hiking the rates, these assets were the most at depreciation risk. However, the core risk management committees of these banks never highlighted these risks. In the case of SVB, the monetization happened at a steep loss, which only worsened the crisis perception. Many of these smaller banks had to resort to selling their HTM (held to maturity) bonds at steep losses, further driving these banks towards bankruptcy. The absence of secured funding sources worsened the crisis.

How the risks were addressed in the last one year?

The March 2023 banking crisis in the US may have come as a rude shock, but the good news is that banks have moved on a war footing. Here are some of the steps that have been taken and steps that are being contemplated to avoid a repeat of such a crisis in future.

• One of the important changes that US banks have done in the last one year is to reduce their dependence on HTM portfolios for liquidity purposes. Instead, they are adjusting the composition of their HQLA portfolios, and enhancing their ability to tap different sources of liquidity. Most of the mid-sized banks have also been updating their contingency funding plans; and the net impact has been improved banking stability. 

   

• One area where the Fed is also working is to improve the willingness of the bank to tap the Fed’s discount window and to enable easy access even in normal times. The discount window provides ready access to liquidity, including when market funding comes under strain. However, access to the discount window in normal times has stringent collateral requirements and that is something banks are preparing themselves for. Banks have started to manage higher reserve levels in general to avoid any liquidity surprises.

   

• More importantly, there is the imperative need to closely monitor market conditions well before pressures emerge. It is about being prophylactic rather than being therapeutic. One of the key risk factors in the US banking crisis was that smaller and mid-sized banks have concentration of deposits and concentration of loans. Hence, there is a risk on the assets side and liability side. Hence frequent assessment of risks of these banks based on liquidity, asset quality and profitability may give early warning signals to prevent a crisis like March 2023 in the future. 

The core point that the Fed wants the markets to take away is the banking sector is sound, and has inherent check and balances. However, a combination of international, external, and regulatory monitoring on a real time basis can help to mitigate many of the risks. The experience of the past has been that Black Swans are already tough to handle with disruption. The secret lies in not allowing a small problem to become a Black Swan event!