There’s still a ton of uncertainty and speculation plaguing the US banking sector, but even if policymakers manage to stem the bleeding, SVB has thrown a spotlight on bigger problems lurking in the financial system.
The big concern now is not just one of solvency, but of liquidity.
Bank holdings of securities like USTs and MBS have gotten a lot of headlines, but bank lending has grown considerably over the last 18 months, even as the amount of bank reserves has fallen >$1.2 trillion.
Meanwhile, banks have been slow to raise deposit rates, so the outflow of deposits from the banking sector has grown in search of higher-yielding alternatives like MMFs.
We’re now facing a situation where the asset side of bank balance sheets has shifted in favor of more longer duration illiquid assets while bank liquidity (cash) is trending lower.
The steep drop in bank reserves – which are a key source of liquidity – is a growing concern especially as the % of illiquid assets on bank balance sheets grows.
The problem is longer duration assets are more vulnerable to price declines in a rapidly rising interest rate environment, making it more difficult for banks to shore up liquidity if the need arises.
If demand for cash increases, or the rate of deposit withdrawals accelerates, banks could face bigger liquidity mismatch issues.
The most common types of longer duration assets (i.e. USTs, MBS) have seen substantial losses in a relatively short period of time, sparking serious concerns about bank capitalization if these losses were to be recognized. Long-dated USTs, for example, are down ~25% since the start of 2022 (and 35% from prior 2020 highs).
If a smaller bank needs to shore up cash quickly – say to service an increase in withdrawals – and it doesn’t have enough cash on hand, it would need to source liquidity from somewhere. It could try and sell securities it holds, but if its assets have declined in value the bank would have to recognize those losses, which could put equity capital at risk.
That’s essentially what the new Bank Term Funding Program (BPFT) aims to solve. Rather than sell their assets, the BPFT allows banks to pledge their holdings of high-quality liquid assets (HQLAs), like USTs and MBS, in exchange for cash to finance their liquidity needs.
The kicker is these bonds will be valued at par, essentially ignoring any MTM losses on pledged collateral. In other words, banks can borrow more than the market value of these bonds and they don’t have to sell their assets and realize any expected losses.
This could serve as a near term boost to liquidity conditions, especially considering banks are sitting on ~$620 billion in unrealized losses, according to the FDIC.
Given its availability to smaller lenders – where much of the concern lies right now – we’ll be tracking loan data of the new program closely to get a sense of how serious banking liquidity needs are (BTFP loan data will be published weekly going forward).
Until Something Breaks
On a final note, there are some notable similarities between current market conditions and those that forced the Fed’s hand back in 2019. The spike in repo rates – which was driven by banks’ unwillingness to lend cash in favor of holding more reserves – was a catalyst for the Fed to inject liquidity to stabilize repo markets.
At the time, Fed officials were quick to control the narrative that this was not a return to QE but rather a response to meet the heightened demand for cash. Bank reserves had drawn down considerably leading up to that point too, not unlike today (albeit at a much faster pace than 2018-2019).
We’ve been saying the Fed would continue tightening until something breaks – and this may be the start of something breaking.
The Fed’s bold response to backstop bank deposits may very well be a stepping stone to more intervention, if history serves as any guide. QT’s days are numbered, in my view.
This is a short preview of a more detailed Markets report we’ll be publishing soon. In the meantime, our Markets Year Ahead report is worth a read (or reread) as it discusses several important trends related to this topic, many of which are becoming increasingly relevant.
