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Topics: The Fed, Reserve Requirements, SVB, Financial Banking System Stability, Free $$$, Illiquidity
“Oh no Drake, were you invested in SVB?”
No, I wasn’t. I intentionally avoided financial stocks for a reason…
Before we begin, I’d like to say that hindsight is always 20/20 and we can all say “we knew this was coming”, though that’s far from the truth. Predicting events like these are extremely difficult, though many factors pointed to systematic issues arising from recent trends in the economy.
We’re going to get pretty intense pretty fast, so for starters, here’s some preliminary information on the Fed, why it’s important, what it does, and what it invests in.
Let’s get into it…
How’d We Get Here
Let’s start this section by blaming covid… again.
I think you remember what happened - covid strikes, the world freaks out, and the Fed, just like most dads, says “How can I fix this for you?” Big S/O to my dad for always helping me fix things, whether it’s my baseball swing or my attitude haha
Here’s what followed:
We’ve talked a lot about QE and interest rates, so I’m going to touch on reserve requirements before continuing to the meat of this article…
A Lil’ Primer on Required Reserves
Without going into too much detail on reserve requirements, they aren’t material (according to the Fed) due to the Fed’s shift in policy to ample reserves. Here’s what they said:
It may not matter according to the Fed, but this change reduced required reserves by an estimated $200 billion.
The ample reserves framework helps the Fed maintain more effective control over short-term interest rates and the Fed Funds rate through Administered rates (interest on reserve balances and offering rate on reverse repo transactions).
What are ample reserves? For more info (in increasing levels of complicatedness), check out this video, this article, or this article.
For live data on the prevailing administered rates, check this out from my buddy FRED.
What you need to know is that higher interest rates make it more expensive to borrow money, increasing the incentive for banks to hold more reserves (so they don’t have to borrow at higher rates from the Fed or other banks).
The SVB Debacle
Everyone is talking about this, so here’s a quick summary with some additional links for you data-loving finance geeks.
Banks take customer deposits and use that money to invest in other assets and securities; in exchange, they pay an extremely small interest rate to borrow that capital. Once customers started pulling deposits, the bank started selling securities and, because the price of its assets fell due to higher interest rates, it did not have enough cash to be properly capitalized (based on required regulatory capital), creating a run on the bank because everyone wanted their money; their reserves weren’t large enough to cover their regulatory capital requirements.
For more, here’s the best overview I’ve read. Here are the bank’s numbers.
Why You Mad Bruh?
The Federal Reserve has several objectives:
Conduct monetary policy to achieve maximum employment and stable prices.
Promote the stability of the financial system by minimizing and containing systemic risks.
Promote the safety and soundness of individual financial institutions.
Foster payment and settlement system safety and efficiency.
Promote consumer protection and community development.
The Fed’s goal has been almost explicitly focused on achieving stable prices at any cost. High inflation has costs and real impacts on the economy… but so do higher interest rates, especially at the pace at which the Fed increased them.
Ever since the Fed started raising interest rates, the narrative has been dominated by lowering inflation, reaching a sustainable employment level, and achieving a normalized economy. The Fed and the market were impatient…
Considering it takes at least 12 months for the full impact of interest rates to be realized through the economy, I find it fascinating that we are almost exactly 12 months from when the Fed first started raising rates… must be some sort of coincidence…
Why Is This An Issue?
Okay, so the 2023 kill count is at two thus far: SVB and Signature Bank, with several others possibly on the way.
The treasury has backstopped SVB and guaranteed all of the bank’s deposits, even those above the $250,000 FDIC insurance cap. The Fed has set up a $25 billion fund should further liquidity pressures arise. This is done to ensure that further turmoil doesn’t spread throughout the banking system (i.e. that more people don’t move to withdraw deposits). As we’ve seen, however, deposits are already falling…
Prior to 2022, there had only been 10 quarters of deposit outflows in the US in the past fifty years; we’ve now seen four quarters of outflows. Yikers…
This is a direct result of lower consumer savings, falling net worth, and falling net disposable income as a result of higher expenses. Banks, however, will not agree with this.
On whether deposits are still high, Bank of America’s CFO said in 2022 that “The question that we get occasionally is, are you seeing (deposits) flow out? The answer is ‘no’.” That, of course, was during 2022…
In 2023, deposits were definitely falling and BofA’s CEO said that falling deposits were a result of:
Higher tax bills from the 2021 increase in wealth.
Shift from savings and checking accounts to higher-yield accounts, Treasuries, and other safe(ish) investments.
Corporate customers are moving money from non-interest bearing to interest-bearing accounts.
“Less affluent people are spending more, in part due to inflation.”
Banks, of course, are incentivized to say that falling deposits aren’t an issue, as it could soon become a self-fulfilling prophecy.
Bank Runs and Herd Mentality
Are you scared that you won’t be able to access your money in the bank?
If you said yes, then you probably aren’t alone.
Bank runs are “a bad equilibrium where everybody demands his deposit anticipating that the bank’s asset value is lower than the deposit value. This process leads to the worst outcome for all participants: We have a destroyed risk-sharing between agents, lower savings returns up to complete losses of deposits, an interruption of real economic processes through loan callings and contagion effects.”
A bank run could occur, even if sparked by a false story, which is what happened to Metro Bank in the UK. What started as a WhatsApp rumor that the bank was going out of business turned into a bank run that resulted in the loss of 24% of the bank’s retail customers.
Once news spread that SVB was attempting to raise capital, depositors quickly went online and to branch locations to withdraw funds and, within hours, the bank was closed.
What’s This Mean For You?
There were many idiosyncratic effects at play with SVB, such as:
Their significant exposure to long-dated treasuries
Large exposure to startups
Lack of interest rate hedges
Does this impact the wider banking system? It could.
Are you going to pull all your money out of your bank account?
If you, your friends, and their friends pull their money out, then you better believe there will be more trouble. The success of our financial system is dependent on its perceived trustworthiness and public confidence. Without the trust of depositors, banks wouldn’t be able to borrow or lend effectively.
The Fed and Treasury have signaled their commitment to backstop SVB accounts and other banks with “liquidity issues”; this was done to meet the Fed’s objective of ensuring financial stability because it gives you (the depositor) comfort in knowing that your money will be there when you need it (even if something happens to the bank).
Will This Become Widespread Financial Chaos?
It could. I have a hard time thinking that depositors will lose complete trust in the financial system. If the Fed, however, keeps interest rates elevated, it could result in job loss, falling disposable income, and decreasing wealth; these factors could force depositors to withdraw funds, putting pressure on banks. Smaller banks without ample reserves could get hit hard, but I think the Fed would put its foot down on further instability in the financial system.
If you evaluate things over the long term, I think this has created one heck of an opportunity to add financial stocks (and other discounted stocks) to your portfolio. Many banks have ample liquidity and are also currently (partially) backstopped by the government.
This is not financial advice or a recommendation, but many large banks are too big to fail and the Fed won’t allow 2008 to repeat itself. In my opinion, of course.
In Conclusion
The Fed did everything it could to support the financial system during covid, including removing reserve requirements.
The sale of specific assets forced the bank to raise additional capital due to inadequate regulatory capital - there were many idiosyncratic factors that influenced this.
Raising interest rates this fast is causing unforeseen issues, as it’s never been done this quickly before.
Bank deposits are slowly falling, though admission that there are issues in the financial system would quickly become a self-fulfilling prophecy.
The financial system has a backstop with the Fed and Treasury, but continued interest rate increases could put more financial pressure on depositors and force them to pull deposits.
Till next time…