In this article:
Since the collapse of Silicon Valley Bank earlier this year, Fidelity International’s Global Macro team has developed a bank stress index that tracks the impact on the financial sector of the Fed’s sharp rises in interest rates and a range of other shocks over the past two years.
Though the collapse of First Republic has not yet been reflected, the index actually fell in the two weeks to May 2, showing an easing of the crisis, and the three banks to have succumbed to the pressure so far were all outliers when measuring weakness by percentage of uninsured deposits and tangible common equity ratio (capital adequacy).
While some selling of regional bank stocks has followed, the orderly takeover of First Republic this week, with all depositors made whole, should help stave off the risk of system-wide contagion, particularly in combination with the broader emergency measures the Fed has put in place.
However, vulnerabilities in the US banking system remain, having been seeded by the unprecedented injection of liquidity during the Covid crisis and triggered by what are now the steepest interest rate hikes since the 1980s, and we are firmly in risk-off mode. A hawkish Fed and the tightening of the availability of credit, exacerbated by the banking stresses, raises the chances of a hard landing in the US over the next 12 months.
In taking over First Republic, JP Morgan purchased a substantial majority of the bank’s assets and liabilities, and the deal allows for a cleaner execution and lower loss to the FDIC, the US government’s depositor insurance fund. From an industry standpoint this is a positive development, removing the name most under stress and alleviating contagion risk in the system.
Much of the pressure in banks’ securities portfolios came as 10-year Treasury yields approached 4 per cent and the market started to focus on what the fair values of those securities were. Marking 5-10 year bonds to their market value after yields rose from 1.5 per cent to 4 per cent put SVB and First Republic at risk. This should not prove a huge issue for those banks that have widely diversified deposit bases or insured retail deposit bases. They are simply less susceptible.
However, there are other banks that could continue to face pressure, particularly if rates move higher again. Politically, the deal will also keep issues in focus around banks that are too big to fail. Relatively, the US banking system is much more diversified than its peers. Most countries have only a handful of banks: in Switzerland, UBS holds multiples of the country’s GDP, whereas JP Morgan’s $3 trillion in assets are only a fraction of US output. But investors must all have tremendous confidence in such big banks’ ability to manage different cycles.[ST1]
Credit squeeze deepens
Problem number two, however, is that as short rates stay higher, corporate borrowers will come under more pressure. That is a credit question – for example in commercial lending or commercial real estate (CRE) - and will continue to stress the system. Eventually the credit issue will get worse, and banks will try to build up reserves in anticipation over the next quarter or two.
Different types of credit will deteriorate faster. We are starting to see it in CRE; also in credit cards, particularly in sub-prime and lower. But stress is less likely to show up in mortgages, and most areas of commercial lending.
As CRE loans come up for refinancing, the primary takeaway is that exposures for US banks are manageable, but the effects will trickle down through the system. Banks will tend to take over properties where loans turn bad and classify them as Other Real Estate Owned (OREO), limiting the losses but taking up space on balance sheets. In the Savings and Loan crisis of the 1980s and early 90s, system OREO reached $50 billion dollars and took a decade to work through. That suggests a truncation this time of the amount of credit banks will be able to put into the economy.
Taking JP Morgan estimates for cumulative loss rates across various types of real estate loans and the reserves that banks currently have against CRE, potential losses from CRE deals could lead to banks building reserves over the next four years. The range will be large: for some institutions it could be 1-2 per cent of earnings, whereas for others it could be as high as 15-20 per cent.
The good news for the financial system is that banks in trouble are getting regulatory backstops. But financial stability focused liquidity is not the same as macro liquidity, or the credit and lending that ultimately is available in the real economy. This will suffer as banks become more risk averse, especially the smaller regional banks. The screws are being tightened and that pressure is coming to bear on the economy.
Our models suggest a further 15 percentage-point tightening in lending standards as a result of the ongoing stresses in the US banking sector and we now believe that overall credit lending will start to contract within the next 6-9 months. The risks are not systemic because liquidity is being deployed and solutions are being chalked up. But that does not add up to a healthy credit lending environment.
You need credit to fuel the economy, and the main engine is the banks. That engine is likely to slow down dramatically. The Fed will push ahead with a rise in rates this week, and some sort of signal towards rates being higher for longer. But it will be a tricky meeting, haunted by the need to reconcile such moves with the banking sector problems. Into this add the US government debt ceiling crisis. US CDS spreads have risen in recent days and the issue has the potential to add more volatility and more political divisions at a time when a fragile system would benefit from consensus.
The current situation is still very different from 2008, when the crisis was driven by credit risk centred in the US housing market. The main source of the problem now is duration risk, which has created confidence issues for the country’s regional and smaller banks. The response of policy makers this time around has also been far more agile and the current shock is likely to be slower moving as a result. But it is still a shock, and it will manifest itself through the tightening of lending standards and the constriction of credit for the economy going forward.