While the contagion of SVB, Signature Bank, and Credit Suisse has been swiftly contained, cracks of confidence in the financial sector may be forming as analysts shift their attention toward asset and liability quality.
Higher interest rates have finally shown their teeth. As noted by Old Mutual, before SVB, the rapid increase in interest rates seemed to have little impact on economic activity. Although several reasons may explain it — more resilient than expected US and European economies, higher inflation offsetting higher financial burden, the time lag needed for higher rates to trickle down to the economy — given the recent events, it seems that the last reason prevails.
Thanks to the prompt actions of policymakers, the recent financial sector stress has yet to have a fundamental impact on the banking industry. Most managers (SSGA, JPM AM, Franklin Templeton, Amundi, etc.) think that the US and European banks are much stronger than during the previous crisis. Large systemic banks have a higher capacity to absorb unrealized securities losses. The EU's crisis toolkit has improved, and the risk of another sovereign debt crisis is low. Many IMs (Wellington Management, JPM AM, Old Mutual, Aegon Asset Management) expect bank lending to slow down, leading to tighter credit conditions and reducing inflationary pressures. T. Rowe Price highlights the risks to watch, such as a decline in deposits due to prolonged elevated rates and the sensitivity of certain customers to higher interest rates or investment vehicles.
Bank's liquidity drainage and higher costs
The recent bank failures imply that banks may face higher competition for deposits and funding, impacting their net interest margins, earnings, and lending appetite. When interest rates rise, banks are slow to raise their interest rates on deposits but quick to raise the rates they charge on loans.
That is why, even before SVB, banks were losing deposits due to competition from higher-yielding products, particularly money market funds ("MMF"). The pace substantially accelerated in March, according to data from the Investment Company Institute; total AUM of US money market funds grew by over 6% in March versus 1.5% in February and 1.8% in January. It stands at USD 5.2 trillion now. Over USD 300bn flooded US money market funds last month. In the second week of March, they had a record inflow of USD 120bn, the fifth largest ever, according to Western Asset. While the inflow has slowed since (only USD 60bn inflow in the last week of March), the pace may remain steady. Ruffer Investment rightly points out that corporate treasurers and investors have no incentives to keep their cash in uninsured deposits when the confidence in banks is questioned, and the yield differential between MMFs and bank deposits is so high.
However, the permanent growth of MMFs can increase their systemic risk. The usage of the Overnight Reverse Repo Program ("ON RRP") by MMFs can lead to risks that are hard to assess. Here is why. The ON RRP borrows cash from MMFs in exchange for US treasuries and other government securities. It was created to provide a floor under the overnight interest rates by offering a risk-free overnight investment for MMFs. The potential problem is that if a very large, unexpected increase in the usage of the ON RRP happens, financial flows can be disrupted. This risk was identified by the Fed in this research paper in 2015. Such a scenario can occur during periods of financial distress; for example, MMF managers can choose to maximize lending to the Fed (because it is risk-free) instead of lending to private institutions and firms, effectively creating a short-term funding crunch for the private sector.
Access to digital currency creates another liquidity leakage to the current system. For example, in its latest paper, the Office of Financial Research discusses how digital currencies may affect the stability of the current financial system. In short, digital currency can similarly destabilize the system by driving liquidity away from the banks. Depositors can choose the digital currency to park their cash instead of banks. While its impact on the system remains limited, digital currency can add additional pressure during periods of stress.
How liability stresses of US regional banks could transmit to the economy is still unclear.
Another implication is that banks may become more cautious about liquidity management and loan growth. We know that regional banks in the US account for a substantial slice of the lending, particularly in the commercial real estate market. A recent analysis by J.P. Morgan estimates that nearly 70% of commercial real estate loans ("CRE loans") in the US sit on small banks' balance sheets. One concern is that banks will refuse to roll over some loans to real estate firms, causing them to go under. According to the Fed's data, commercial real estate lending by banks slowed substantially from Mar 2020 to June 2021 (average monthly growth of 0.2%). Still, it rebounded strongly after that, with an average monthly increase of 0.9% until February. December 2022 recorded the highest year-on-year growth since the GFC, with 13.5%. Since SVB and Signature Bank failed, CRE loans have been attracting attention. For example, when New York Community Bank's purchased the assets of Signature Bank, it specifically excluded the multifamily mortgage portfolio.
The CRE market was first pressured by the impact of Covid on the shopping center, lodging, and office sub-segments. In 2023, Aegon Asset Management expects all sub-segments except retail to be challenging due to sizable supply and weak demand. The spotlight is on office properties as office use has not recovered from the Covid recession due to persisting work-from-home policies. Tenants are recalibrating their office space needs; in parallel, expectations of an economic slowdown are eroding business expansion plans while the tech sector is downsizing and giving up office space.
Historically, one way out of CRE loans for banks was to package and sell mortgages to investors. Still, the market for commercial mortgage-backed securities (excellent refresher/explainer on CMBS here) has been extremely soft for several months, limiting the ability of banks to move loans off their books. Private-label commercial real estate bond issuances fell to USD 78.5bn last year, down 58% from 2021. Recent high-profile defaults add to industry caution. Blackstone defaulted on the first European CMBS in early March. A week earlier, Columbia Property Trust, owned by PIMCO, defaulted on USD 1.7bn worth of bonds. In early February, Brookfield defaulted on USD 350m CMBS issued in 2021.
That said, credit distress from office mortgages may play out slowly, driven by the overall maturity schedule and lease expiries. And the scale of the problem will depend on the size of the maturity wall and the extent to which weaker economic activities weigh down on debt servicing capability.
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