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The Banking Crisis: Too Soon to CelebrateThe Banking Crisis: Too Soon to CelebrateThe Banking Crisis: Too Soon to CelebrateThe Banking Crisis: Too Soon to Celebrate
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            INSIGHT • 12 APRIL 2023

            The Banking Crisis: Too Soon to Celebrate

            author-validus

            Pierre Roke, Senior Analyst


            In the wake of last month’s banking crisis, it is important to reflect on lessons from this ‘scare’, draw comparisons from similar macroeconomic events and, although some parts of the market have moved on, analyse what lasting effects it may have. As Silicon Valley Bank's (SVB) depositors began withdrawing their funds, SVB was forced to sell its held-to-maturity assets at a significant loss, triggering the beginning of the end for the bank and serving as a stark reminder of the severe consequences a bank run can have on the economy. After it became clear that the risk of contagion was less than initially feared, Credit Suisse suffered its own reminder, which sparked another bank run and resulted in its takeover by UBS at over half its value.

            Now that the market has started to recoup its losses, it is worth considering the lasting effects of these events and what they might mean for the banking sector going forward. Analysis of the market response to the threat of a severe banking crisis provides valuable insights into what might have happened had contagion occurred. The initial ramifications were evident, with significant drops observed in the rates and equity markets, drawing a clear comparison to the Savings and Loans Crisis (S&L) of the 1980s. These events have likely shaken investor confidence in the banking sector, and it remains to be seen how banks will adjust their risk management practices to prevent future crises.

            Looking at inflation and interest rates in today’s economy, parallels with the S&L crisis are clear. Although multiple factors contributed to this recession, inflation was a significant one, as is the case today. Inflation began to rise in the mid-1960s and continued to climb until it reached levels above 14% in 1980. A key reason for this inflationary pressure was a series of events that constrained supply, starting with the 'Arab oil embargo' of October 1973, then the 'Iranian revolution' in 1979, which tripled the cost of oil. In response to this, much like the Federal Reserve's current policy, the central bank went through a historical hiking cycle, raising policy rates until they reached levels above 20%.

            These historically high interest rates helped precipitate the S&L crisis, as institutions had made long-term loans at significantly lower rates than they could now fund themselves. In the first half of the 1980s, there was a significant increase in the number of S&L failures, with 118 institutions holding assets worth $43 billion collapsing, which was much higher than the $4.5 billion of failures in the preceding 45 years. From the beginning of 1981 to the lowest point, the S&P index recorded a 15% drop, while two-year rates also fell, from 17% to 12%, over a similar timeframe. Although on a smaller scale, market movements were similar during the most recent banking crisis scare. US two-year rates, which had reached a high of 5.07%, fell to a low of under 3.8%, with the S&P index also experiencing a decline before recovering as the fear of market contagion subsided. If the comparisons are set to continue, we could easily see more volatility ahead.

            In addition to this market volatility, we are likely to see a longer lasting effect on the operations of the banking sector as a whole, particularly within the small to medium US banks (under $250 billion assets). Importantly, these entities are responsible for approximately 50% of commercial and industrial lending, 60% of residential lending, 80% of commercial real estate lending, and 45% of consumer lending in the country. Given their importance within the economy, we anticipate that these banks will face increased regulatory scrutiny, which may lead to closer alignment with the European one-tier regulatory system, focusing on tighter liquidity and capital ratios within the smaller banks.

            Following the crisis, there has been a notable trend among banks tightening their lending standards to improve their balance sheets. While this could be interpreted as a pre-emptive response to a potential regulatory change, we believe that the more probable reason is the heightened risk of bank runs in the small to medium US banking sector. As a result, we expect these tighter lending standards to have a similar impact to that of tighter monetary policy, which will effectively partly bridge the gap between the pre-bank crisis US terminal rate of 5.5% and the current rate of 3.7%.

            Though we believe that ultimately focus will return to the economic fundamentals (employment and inflation), it is too early to call victory on the banking crisis and risk managers should prepare themselves for increased market volatility and difficult funding conditions. If SVB’s foibles have taught us anything, it is to be prepared for even the most “unlikely” of market conditions.

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