Special Update: Navigating Bank Failures, Fed Rate Hikes, and Risks to the Financial System

Special Update: Navigating Bank Failures, Fed Rate Hikes, and Risks to the Financial System
March 19, 2023

The recent bank failures have sparked speculation as to what might come next. In this special update, Dan Kraus MBA, CFP®, CRPC®, APMA® covers how we are navigating these failures, fed rate hikes, and risks to the financial system.

The recent failure of three U.S. banks has raised concerns over the economy and financial system. The situation is still evolving and there is plenty of speculation as to what might come next. One recent development is that government officials from the Treasury, Federal Reserve, and FDIC have announced that depositors will be made whole in an effort to backstop the system and restore confidence. This crisis has already created hardship for many companies and individuals as payrolls are disrupted and access to cash is halted. However, when it comes to investing, it's more important than ever to stay levelheaded and focus on the big picture. What should long-term investors know about these bank failures and what do they reveal about the financial system?

Bank stocks have struggled due to recent failures

The collapse of Silicon Valley Bank (SVB) was the first FDIC-insured bank failure since 2020 and the second largest in history. This was followed two days later by the failure of Signature Bank, the third largest in history. Just a few weeks earlier, these two publicly traded companies had the 14th and 18th largest market capitalizations among U.S. banks, respectively. Silvergate, a smaller bank active in the crypto industry, also failed the same week, but through an orderly liquidation.

From a market and economic perspective, the main question is whether there is wider systemic risk to the financial system. This episode reveals that these particular banks grew too aggressively and with too little risk management as tech valuations rose and crypto prices rallied over the past several years. While this worked well in a bull market, the reversal of these trends in 2022 made these banks vulnerable to classic bank runs.

How do bank runs occur? A simplified description of the classic banking model is that customers – both businesses and individuals - deposit funds for safekeeping. Banks then use these deposits to make loans or to buy high quality investment securities which they hope can generate profits. This works well as long as these investment assets maintain or grow in value and customers trust that their deposits are safe. If either of these is not the case, a bank may not have the liquidity to meet its obligations. With this in mind, these recent failures were due to two related problems.

Banks accumulated unrealized losses on investment securities as rates spiked

First, rapidly rising interest rates and Fed rate hikes over the past year created financial stresses on bank balance sheets. Bonds had their worst performance in history in 2022, driving unrealized losses on investment assets including U.S. Treasuries, as shown in the accompanying chart. Whether banks need to book these losses depends on how these securities are accounted for, but this worsens as banks face pressure on deposits. Thus, SVB and others found themselves with assets that were worth far less as rates rose.

Second, SVB’s concentration of tech and startup customers made it vulnerable as conditions deteriorated for that sector, just as Silvergate and Signature Bank were exposed to the slowdown in the crypto industry. SVB tried to plug this gap by raising fresh capital, but this backfired since it highlighted the liquidity and solvency issues it faced. Like shouting "fire" in a crowded theater, once there is the perception of solvency problems, a classic bank run can occur swiftly, which can then become a self-fulfilling prophecy. To a large extent, this played out publicly as many in the startup and VC communities urged companies to move their funds.

While government actions are always controversial and subject to political debate, moves by Treasury, the Fed, and the FDIC to backstop customer deposits across these banks will likely help to prevent contagion effects across the system. At the same time, it does not directly address the underlying issue of impaired assets which depends on the quality of risk and asset/liability management at each bank. However, the risk that unrealized losses become a solvency issue is mitigated for larger, more diversified banks who are less reliant on deposits, have a stronger deposit base, and maintain higher amounts of capital.

These bank failures are the largest since 2008

One reason that investors may be concerned is that there have been few bank failures in recent history, especially since banking legislation such as the Dodd- Frank Act was put into place after the 2008 financial crisis. According to the FDIC, there were only 8 bank failures from 2019 to 2022, far below the 322 experienced around the global financial crisis or the hundreds that regularly occurred in the 80s and 90s. That said, SVB is an outlier in that it had total deposits of $175 billion while the 8 from 2019 to 2022 had a combined $628 million.

Naturally, there are also parallels being drawn to 2008 when the last wave of bank failures threatened the global financial system. It's important to keep in mind that, back then, the problem was not just that all banks held significant amounts of mortgage-backed securities and other housing-sensitive assets that ended up being worth only pennies on the dollar. Rather, significant amounts of leverage coupled with new financial instruments such as collateralized debt obligations allowed a housing crisis to turn into a financial meltdown. While it's unclear exactly how this episode will play out, many banks today are much better capitalized and do not primarily rely on tech or crypto deposits. Additionally, any economic spillover has so far been concentrated in the technology and venture capital industries which were already struggling with layoffs and a slowdown in demand.

These developments impact the Fed's upcoming rate decisions since they underscore an unintended consequence of rapid rate hikes. It's likely that this creates a new sense of caution for the Fed as they continue to battle inflation. According to market-based measures, investors no longer expect the Fed to raise rates again this year, but believe that there may be a rate cut by September. Interest rates have also fallen with the 2-year Treasury yield declining over one percentage point to around 4.1%. While these expectations can change rapidly, they show how much sentiment has shifted in the past week.

The bottom line? While recent bank failures are problematic, parallels to 2008 are premature. Investors ought to stay diversified as the situation stabilizes, while focusing on the big picture rather than minute-by-minute speculation.

So what is the big picture? Mixed signals.

From an economic view, the US GDP is expanding again even while the money supply is contracting. This is a healthy sign that, at least so far, the economy is managing the storm of Federal Reserve credit tightening. And while the bank failures discussed above, and the recent escalation in layoffs, are definitely signs of cracks in the health of the economy, overall measures of economic conditions at this point are mixed. For example, the ISM Manufacturing Index shows clear slowing and recessionary readings, while the ISM Services Index is still positive indicating economic expansion.

How do the economic mixed signals translate to the stock market? The markets move sideways. As you can see from the chart below, large US company stocks are trading at the same price as March of 2021 and May of 2022. While the media is full of theories about why stocks should plunge or skyrocket... sometimes stocks just move sideways. When the economy is sending so many mixed signals, that is often what happens.

This kind of consolidation is very healthy over the long-term. It allows the weaker companies to close or be bought, while the stronger ones have the opportunity to make their businesses more efficient in preparation for the next leg of growth. While frustrating for investors, markets do not always grow in a consistent manner. Sometimes growth is slow or zero, sometimes it is fast, and sometimes it moves in reverse for a short period.

Looking forward and looking up. In our last market commentary in Q4 2022 we discussed that investors will need patience in the coming months while interest rates continue higher. That reality is still in place, and the Federal Reserve (and global Central Banks generally) are not done tightening financial conditions.  However, while markets can always go lower when sudden crises happen, we are likely nearer to the end of the bear market caused by the Federal Reserve rate hikes.

What would cause the market to rally, possibly as soon as the 2nd half of 2023?  Anything that can cause corporate earnings to rise. A few ideas are currently coming into focus:

• The rapid introduction of artificial intelligence tools could dramatically improve productivity in the Services sector of the economy, something that was lacking in the prior expansion. In particular, the cost of software development, legal services, medical services, and customer support may start to fall in meaningful ways over the coming years as a result of AI. That is without some of the larger potential developments like self-driving cars.
• Hybrid/remote work means smaller office real estate footprints. While this may not be ideal for landlords it is clearly good for corporate earnings.
• Companies, particularly in technology, are starting to get religion on efficiency and reducing spending. When leading companies like Meta (Facebook), Apple, and Amazon start to cut back on staffing growth, and perks generally, it has a strong influence on the rest of businesses.

As we have said in the past, the seeds of the next rally are always sown in the midst of the current downturn. This time is no different.

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