Bank Failures Put Fed in Hot Seat
Federal Reserve officials are coming under fire as they convene a two-day policy meeting March 21-22. The events of the past 10 days, where the FDIC took control of Silicon Valley Bank (SVB) and Signature Bank, and the Swiss National Bank had to throw a lifeline to scandal-ridden Credit Suisse, Switzerland’s second-largest bank, the Fed’s policies and oversight are putting the central bank in the hot seat.
Although many of the problems at the three banks in question were unique to them, the broader issue may be that the Fed and other global central banks kept interest rates too low for too long. Low or zero percent interest rates can help fuel growth, but it can also lead to outsized risk taking, both among individuals and businesses. Compounding the problem, central banks were slow to start their inflation-fighting campaign, and as it turns out, inflation was not “transitory”. When the banks recognized their mistake, they essentially slammed on the brakes, which as any driver knows, can cause a skid, a spin-out or in the worst case, someone flying through the windshield.
A little context as to how we arrived at this destination. After the financial crisis, the Federal Reserve slashed short term rates to zero and held them at that level from December 2008 until December 2015, an unprecedented amount of time. The rationale was that the economy suffered a dramatic shock after the financial crisis and the Great Recession. Low rates were necessary to spur borrowing and lending, allowing individuals and companies to get back on their feet.
From 2016-2018, the Fed slowly nudged up rates, but they remained historically low. At the peak of that campaign (December 2018), the fed funds rate stood at 2.25 – 2.5 percent. Compare that range to the previous expansion in June 2006, when rates stood at 5.25 percent. In 2019, spooked by slowing growth (GDP was at 1.9 percent in October 2019), which was caused in large part to Trump’s trade war (and maybe influenced by Trump tirades directed at the Fed and Jay Powell), the Fed cut rates three times for a total of a 0.75 percent reduction.
When the pandemic hit, interest rates were already low (1.50-1.75 percent), which meant that the Fed did not have a lot of room to maneuver. Still, over the course of two weeks in March 2020, they cut rates to zero, which is where we were until a year ago, when the Fed began its aggressive rate hike campaign.
Additionally, as the Fed kept rates low amid COVID-19, there was a lot of money sloshing around the economy in the form of stimulus relief efforts and there were pandemic distortions playing out. For example, spending shifted to goods from services, savings piled up and twitchy venture capital firms desperately needed to find investments for their burgeoning cash coffers.
And here is where our threads meet: with a lot of cash on hand AND interest rates low, many were lured into risky investments. After all, why keep your stimulus check in a zero percent savings account when you could buy a meme stock or crypto? Similarly, if you are a VC firm and your clients have handed over money so that you can invest in the next, best thing, you may cast your net a little wider for ideas, perhaps throwing money at companies whose business premise was based on pandemic conditions persisting forever. And if you are a bank that is sitting atop a mound of deposits, perhaps from those very companies that were handed VC money, why keep all of those deposits in easily accessible money that is paying zero, when you can purchase a “safe”, longer-dated treasury or mortgage-backed security, that will increase that amount of interest you can earn?
While some decisions made during a low-interest environment can be awesome (i.e., a 30-year fixed rate mortgage for under 3 percent), others can catch you flat-footed and bite you in the tuchus, when rates start to rise. The Fed’s inflation-fighting rate hike campaign, which has seen fed funds go from zero to 4.5 percent in 12 months, hurt high growth sectors like tech and also banks like SVB, which held longer dated bonds. In other words, when the Fed slammed on the breaks, certain parts of the banking sector went flying through the windshield.
THE FED’S OTHER JOB
In addition to its role as “lender of last resort” and manager of monetary policy, the Federal Reserve is the prudential regulator of the U.S. banking system. That means that they strive to ensure the safety and soundness of individual institutions and maintain overall financial stability. To do so, they, along with the OCC and state regulators, oversee and supervise the nation’s banks.
In this role, there are likely to be many questions. For example, SVB was subject to scrutiny by the state of CA and the Federal Reserve Bank of San Francisco. As Henry Engler of Regulatory Intelligence wrote: “The risky mix of long-dated Treasury securities and higher-than-average uninsured deposits [uninsured deposits are seen as risky, because they are usually the first dollars to leave a bank when there is a problem. The reason is that these depositors understand that they are not protected by FDIC insurance] should have been red flags for the Federal Reserve in its periodic examination reviews, experts and former regulatory officials say. Why they failed to act to avert what appeared to be a crisis in waiting is what many will want to understand.” Engler goes on to note that in its Q4 2022 report, the San Francisco Fed, “identified major deposit risks for SVB and other banks that it oversees in the western region. Why weren’t the “red flags” raised by such information sufficient for the San Francisco Fed to intervene and work with SVB to avert a potential crisis?”
Although we are still in the eye of the storm, these and other questions will be debated among regulators, legislators, and banks themselves. In the meantime, the Fed has another policy meeting on tap. Will the central bank pause its rate hike campaign due to the ongoing issues in the banking sector or use a smaller rate hike of a quarter of a percent to beat back still high prices? Stay tuned.