The Fed decided to continue the monetary tightening with an interest rate hike of 25 bps at their latest meeting on March 22nd, pushing the fed funds rate to 4.75%-5.00%. The underlaying problem has been out of control government spending in various forms, both related to Covid and other spending packages in the trillions. As a result, inflation is the highest since the 1980ies. For some reason, the Fed waited and waited before taking any concrete steps to deal with the inflation problem and as a result, they have increased the interest rate at rapid pace during the last year. At the same time, inflation is still running high, well above the target of 2%, so it will be difficult for the Fed to suddenly ease the policy. By increasing the interest rate so much and so quickly, the borrowing cost has increased significantly for lenders. This is putting much strain on the financial markets and on the banks. To date, both Silicon Valley Bank and Signature Bank have failed, and Credit Suisse has been bought by UBS to basically save the bank. This development is worrying and even more worrying as the Fed keeps increasing the rate. At some point, the banks will have significant liquidity problems and there will likely be continued capital outflow given the uncertainty.
What has created even more uncertainty and confusion is the government’s handling of the situation. As they are the main reason for the current crisis, one sense a level of incompetence in handling the situation properly. Treasury secretary Janet Yellen, an economic dove, has been making conflicting remarks throughout the week regarding the government providing de facto guarantee on all U.S. bank deposits. The Biden administration mixed signals are becoming another threat to the financial system as it creates more uncertainty. The threshold for deposit guarantees is $250,000, but is the administration saying they will guarantee any deposit amount? It is not clear. When Yellen spoke and did not give a concise message, the stocks tanked as a result. At this point no one is sure whether uninsured depositors will be covered other than at the giant banks that have been deemed too big to fail.
The treasury department has not clearly explained why protecting uninsured depositors at Silicon Valley Bank or Signature Bank was necessary to prevent a system risk. Midsize banks have been lobbying regulators for a blanket guarantee of all deposits. This would likely not be a good solution as risk is part of the banking system and there needs to be a continued trend of consolidations for stability. Weaker banks will have to continue to go under or be acquired or merged into larger and stronger banks. That is the nature of the banking system a la Charles Darwin.
Failures in the current banking systems are not results of poor regulations, but rather results of poor risk management by the banks, incompetent leaders, high risk taking and poor compliance. Politicians in Washington DC might see an opportunity to regulate more, but what the financial system needs is discipline and clear messages. At some point there will be a realization that government spending has been out of control and that the Fed increased the rates too late and too fast for the financial system and there will be a price to pay. Likely a modest recession and some weaker banks might have to go under.