There are four reasons to worry that the latest banking crisis may be systemic. For many years, periodic bouts of quantitative easing have expanded bank balance sheets and filled them with more uninsured deposits, making banks increasingly vulnerable to changes in monetary policy and financial conditions.
CHICAGO – The recent banking collapses in the United States seem to have an obvious cause. 90% of deposits at Silicon Valley Bank (SVB) and Signature Bank were uninsured, and uninsured deposits are understandably prone to runs. Also, the two banks had invested large sums in long-term bonds, whose market value fell as interest rates rose. When SVB sold part of these bonds to raise funds, unrealized losses on its bond portfolio began to come to light. A botched equity offering then sparked the run on deposits that ended up sealing its fate.
However, 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 implements quantitative easing (QE). As this involves buying market securities in exchange for the central bank’s own liquid reserves (a form of cash), QE not only increases the volume of the central bank’s balance sheet, but also causes an expansion in the balance sheet of the banking system in and your uninsured demandable deposits.
Along with other coauthors, we called attention to this underestimated figure in a paper presented at the Fed’s annual conference in Jackson Hole in August 2022. When the Fed resumed QE during the pandemic, uninsured bank deposits went from about 5.5 trillion dollars, at the end of 2019, to more than 8 trillion dollars in the first quarter of 2022. At SVB, deposit income grew from less than 5,000 million dollars, in the third quarter of 2019, to an average $14 billion per quarter during QE. But when the Fed ended QE, raised interest rates, and moved quickly into quantitative tightening (QT), those flows reversed. SVB began to see a greater outflow of uninsured deposits (which, in some cases, coincided with the crisis in the technology sector, when the bank’s troubled customers began withdrawing cash reserves).
Second, many banks, after benefiting from the influx of deposits, bought longer-dated, liquid securities such as Treasuries and mortgage-backed securities to generate a profitable carry: an interest rate spread that offered yields above of what banks had to pay for deposits. In general, this procedure need not have been risky. Long-term interest rates hadn’t moved for a long time, and even if they started to rise, bankers know that depositors tend to get sluggish and will accept low deposit rates for long enough, even if market interest rates rise. As a result, banks felt protected by both history and depositor complacency.
This time, on the other hand, it was different, because it dealt with elusive uninsured deposits. Having been generated by a Fed action, they were always ready to go when the Fed changed course. And, because large depositors can easily coordinate with each other, actions taken by a few can trigger a cascading effect. Even in strong banks, depositors who are aware of bank risk and the healthier interest rates offered by money market funds will want to be compensated with higher interest rates. Juicy interest rate spreads between investments and sleepy deposits will be threatened, with consequent damage to profitability and bank solvency. As a saying goes in the financial sector: “The road to hell is paved with positive carry”.
The third problem is that these first two elements have been magnified today. The last time the Fed implemented a QT and interest rate hikes, in 2017-19, the rise in policy rates was smaller and less sudden, and the volume of securities sensitive to changes in interest rates that the banks had was lower. Consequently, the losses that bank balance sheets had to absorb were small, and there were no runs on depositors, although the ingredients were largely the same. This time, the volume of interest rate increases, their speed, and bank holdings of assets sensitive to interest rate changes are much larger, and the Federal Deposit Insurance Corporation suggests that losses from just holdings of available-for-sale and to-maturity bank securities could exceed $600 billion.
The fourth problem is a lack of supervision coordination with the industry. Clearly, many supervisors failed to see banks’ increasing interest rate exposure, or were unable to force banks to reduce it. If supervision had been stronger (we still haven’t been able to determine the level of inefficiency), fewer banks would be in trouble today. Yet another problem is that supervisors did not subject all banks to the same level of scrutiny that they applied to the largest institutions (which were subjected to stress tests, among other things). These differentiated rules may have caused a migration of risky commercial housing loans (think of all the half-occupied office buildings during the pandemic) from larger and better capitalized banks to small and midsize banks with relatively weak capitalization.
The bottom line is that while many vulnerabilities in the banking system were created by the bankers themselves, the Fed also contributed to the problem. Periodic bouts of QE have expanded bank balance sheets and flooded them with uninsured deposits, making banks increasingly reliant on easy liquidity. This dependency adds to the difficulty of reversing QE and adjusting monetary policy. The larger the scale of QE and the longer its duration, the longer the Fed should take to normalize its balance sheet and, ideally, raise interest rates.
Unfortunately, these financial stability issues 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 demanding that the QT be interrupted. The Fed is again offering large doses of liquidity through its discount window and other channels. If financial sector woes don’t slow the economy, such actions could prolong the fight against inflation and make it more costly.
The result is clear: in re-examining bank behavior and supervision, the Fed cannot ignore the role its own monetary policies (especially QE) played in creating today’s difficult conditions.
Raghuram G. Rajan
Governor of the Reserve Bank of India, he is Professor of Finance at the University of Chicago Booth School of Business and author, most recently, of The Third Pillar: How Markets and the State Leave the Community Behind.
Viral V.Acharya
Deputy Governor of the Reserve Bank of India, he is Professor of Economics at the Stern School of Business at New York University.
Copyright: Project Syndicate, 1995 – 2023
