Shockwaves from Silicon Valley
Problems local US banks cause share price declines
In the tail end of last week, financial stocks in both Europe and the US have experienced a sharp drop in prices – caused by problems at Silicon Valley Bank (SVB), a local US bank in San Francisco. As the problems appear to be an unwelcome consequence of the rapid tightening of central bank policy, all eyes are now on the Federal Reserve’s (Fed) response.
SVB had to take a big loss on (corporate) bonds, as many of its customers withdrew their deposits and the bank had to sell bonds to free up enough money. Due to the sharp rise in interest rates, this was met with considerable losses. The fear in the market was that other banks may also have to take such actions and will have to face such losses as well.
Whether it will proceed at such a pace, depends to a large extent on the customer base of banks. The Silicon Valley Bank mainly has start-ups and venture capitalists as customers. This group of customers sees their money evaporating faster in the current market, due to economic circumstances and the higher interest rates, and therefore has to appeal to its deposits. Banks with a more diversified and less concentrated client base should be able to weather such a storm.
Risks seem limited for large banks
Recently, interest rates have risen sharply in both the US and Europe, while at many commercial banks deposit and savings rates have not risen at the same pace. And the gap between the policy rate of central banks and the bank deposit rate has increased. As a result, banks are seeing a relatively larger outflow of deposits into higher-yielding investments, such as money-market funds. In order to keep more deposit money in and also remain competitive, banks will have to adjust their deposit and savings interest rates. And this can depress interest margin and profits.
The current risk, however, seems to lie mainly with smaller banks with a less diversified customer base. The larger banks are also exposed to these risks, of course, but usually for a (very) small part of the balance sheet. Many of the large(r) banks have a solid capital position, as well as a very strong balance sheet. Also, several banks have converted bonds to variable interest rates in their investment portfolio, so they only bear credit risk on these securities and no longer interest-rate risk. As such, when they experience the same degree of deposit outflow, they are much less affected. It is a clear signal, however, that higher interest rates do not only have positive effects for banks and that the balance between loans and deposits must be managed properly.
Decisive measures from authorities
After shutting down SVB and putting it under control of the Federal Deposit Insurance Corporation (FDIC) on Friday, authorities have managed to stop the bank run at SVB – but not before already USD 42 billion was withdrawn. With this step, authorities bought time to find a solution during the weekend. Two days later, another bank was shut down: Signature Bank in the New York region.
On Sunday, authorities finally came up with decisive measures in order to decrease the risk of a domino effect on financial markets. Officials for example approved that depositors of both failed banks, SVB and Signature Bank, will have full access to their deposits. Authorities, including the Federal Reserve (Fed) and the US Treasury, promised to provide the system with emergency liquidity to head off any deterioration of confidence in other institutions.
What does it mean for Fed policy?
The tightening policy of the Fed is starting to take effect, although the current impact on the financial system is undesirable. After mitigating current contagion, the question is going to be how the Fed will continue its monetary policy. Due to the rapid rate hikes, commercial banks are forced to increase their deposits rates as well, while seeing declining value of securities on their balance sheets.
Last Tuesday, Fed Chair Jay Powell mentioned that current economic data might possibly support a reacceleration of rate hikes. But now that unintended consequences of this policy have sent a shockwave through financial markets, the question is whether the Fed will pause its rate hikes. Next week, on Wednesday 22 March, the Fed will meet and make a rate decision. Until then, speculation about a 50-basis points hike, a 25-basis points hike, a pause or even rate cuts will probably dominate headlines.
What does it mean for our investment strategy?
Tightening central banks have always produced economic and financial impact. That is the reason why we expect that economic growth will decelerate further in coming quarters, that volatility could remain above long-term average in coming months and that our portfolio positioning remains cautious - we maintain an underweight position towards equities. Within equities, we have a neutral stance towards financials and a slight defensive bias with our only overweight on health care.
Joost Olde Riekerink – Equity Research & Advisory Expert
Olivier Raingeard - Global Head of Equity Strategy