March 27, 2023
Investment Strategy Brief: Monitoring Financial Stability Risks
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Below is a transcript of this week’s video:
It’s been a whirlwind couple weeks for the global financial system, particularly in the U.S. after the FDIC takeovers of Silicon Valley and Signature Banks. Less than a quarter of the way through 2023, these two bank failures constitute a combined $320 billion in total asset value, which comes second only to 2008 so far with its $375 billion of failing assets. Last time was a bit different in some respects, as that amount was spread out over a couple dozen more bank failures, highlighting how this recent turn of events is both large and narrow at the same time.
Silicon Valley Bank in particular faced a tough combination of low levels of liquid capital and high share of uninsured deposits. When those uninsured deposits got cold feet and fled to other banks, the sum of cash and liquid securities was not enough to cover deposit flows, contributing to the FDIC’s decision to take over. As this continues to unfold, investors are considering just how widespread these issues may be. Of the top 42 publicly-traded, FDIC-insured financial institutions in the U.S., only 7 share similar characteristics, with greater than 60% uninsured deposits and less than 80% liquid capital to deposit ratios. There are two important caveats here though: 1) this is a broad brushstrokes analysis and it may not account for any other mitigating factors that might put some of these banks at less risk than those that have recently failed; 2) this is based on data from the latest regulatory filings, which are as of the end of 2022 – since then, these banks may have taken steps to shore up their liquidity profiles. But still, since only a relatively narrow set of small banks appear to face these issues, the risk of a systemic event in the U.S. financial system appears contained.
However, investors should not get complacent in times like these and should proactively monitor risks to the financial system. There are some indicators we’re watching in real time to gauge those risks, the first of which is the Fed’s balance sheet. Its assets had been gradually ticking lower as it sought to normalize following the pandemic, but has since ticked notably higher. The main reason for this seems to be various financial institutions tapping liquidity and credit facilities such as the deposit window or the new Bank Term Funding Program. This in and of itself is not necessarily indicative of stress, but could be an effort from banks to defensively posture their asset books in uncertain times.
A couple of spread measures give an idea of any stress popping up in the interbank lending markets. The secured overnight financing rate on the left, which is the cost of borrowing cash overnight remains contained, but the FRA-OIS spread on the right has ticked higher. This rate tends to reflect the risks associated with interbank lending and, while increasing, still remains well below levels observed during the last period of significant financial crisis in ’08 to ’09.
A very similar observation can be made when observing swap spreads. These tend to give us an indication of the market’s view of liquidity and counterparty risks. Whether looking at the dollar swap or asset swap spreads, both have creeped higher but remain well below levels observed during the Great Financial Crisis.
In addition, the yield spread on corporate bonds issued by banks relative to equivalent maturity U.S. Treasury bonds have widened across the spectrum, but are nowhere close to the peak stress levels of the Great Financial Crisis in ’08 and ’09, the European debt crisis in 2011 and 2012 and the COVID-19 pandemic in 2020. So all together here, while broader financial stress measures remain relatively contained, there are some signs of rising liquidity and interbank lending issues that investors should monitor in the unfolding weeks.
One of the follow-through effects from all of this uncertainty in the banking channels is likely to be a further tightening in lending standards as banks avoid taking unnecessary risk in the near-term. The Fed’s Senior Loan Officer Survey, which isn’t necessarily the most timely data point with a latest reading as of the end of 2022, was already picking up on signs of tightening standards across various types of loans. That includes commercial real estate, industrial loans and credit card lines. All of this runs the risk of further tightening, which has historically been consistent with recessions in the U.S. Much of the leading indicators have been calling for a recession for some time now, but this may end up being one of the catalysts that lead to a broader economic downturn if credit dries up enough to affect growth. Accordingly, this is an aftershock risk that warrants a defensive posture for investors in the near-term.
So to summarize, the takeovers of Silicon Valley and Signature banks have brought financial stability issues to fore. Looking beyond that, there are a handful of smaller banks that face similar issues due to a sizable share of uninsured deposits and less than adequate liquid capital. Of the things to watch, it’s clear banks are tapping the Fed’s liquidity and credit facilities to shore up their balance sheets. Beyond that, broader measures of financial stress have ticked higher, but remain contained for now.
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