Banks: Canary in the Coal Mine?
We’ve been through a lot over the last three years. It began with a once in a century pandemic that we were fortunate to survive.
To protect against another Great Depression, the Federal Reserve and Congress made it rain money, which helped keep homes and businesses afloat. These actions had many unintended consequences.
It feels like we’ve been through a generation of crises in only three years.
- Inflation become unhinged in a way we haven’t seen in forty years
- The drop in stocks and bonds last year rivaled the worst bear markets in history
- Falling real estate values in many areas was on par with the housing crisis
- A strange speculative bubble came and went in crypto currency madness
Any one of these events in the financial world, in a vacuum, would have been a catastrophe, but in this era it’s been par for the course.
We’re now heading into what may be the last chapter of pandemic era financial stress. The Fed has been aggressively increasing interest rates to combat runaway inflation, which slows growth by making it more expensive to borrow. Three months ago we were expected to be in a recession by now, yet we’ve had a stellar first quarter, a testament to the strength of this economy. But cracks are finally beginning to form, and those cracks are in banks.
To be clear, this is not a situation where you should pull your money out of banks despite two recent failures. It rarely makes the press, but small town banks do fail, and the FDIC steps in to unwind them. We have a lot of banks in the US.
A recent Bloomberg op-ed notes: “Canada has fewer banks than the state of North Dakota.” Recent events have been eye popping because of the size of the banks that failed. The US Treasury and FDIC have basically guaranteed all deposits at this point to assuage everyone, meaning everyone globally, our banking system is that important.
Silicon Valley Bank and Signature bank were victims of poor management and classic runs. Deposits were pulled in a panic, and the banks were forced to sell bonds at losses on a massive scale to meet the demand for cash, which crushed them.
While deposits are implicitly protected, all banks are under similar stresses. They must hold a certain amount of very safe bonds as capital, these requirements were bolstered coming out of the great recession. These bonds have dropped in value with increasing interest rates, which means many, if not all, are holding massive amounts of bonds at a loss. This gets ugly if they are forced to sell, which is how runs feed on themselves. Either way, bank balance sheets are in a fragile state because they all face similar requirements.
Regulators were certainly aware these issues were festering across the board, but between the capital requirements and increasing rates, everyone is holding the same bad hand.
Regulators, facing public glare, will insist they improve balance sheets as quickly as possible, which means lending standards will tighten. Over the next several months this will create another drag on the economy. Banks lending less means businesses of all sizes will have less working capital.
The ironic upside, this dynamic will cool inflation. Inflation still needs to drop by at least 50%, and the bank balance sheet contortion will mark the beginning of the end of rate increases for the Fed because it can’t afford to trigger another full-blown crisis.
The bottom line: the bank balance sheet issue could mark the catalyst for the long-anticipated slowdown. Over the last several months expectations for a serious slowdown or recession have shifted to midyear, and this aligns with that timing. While stocks will not like this, they haven’t gotten too far ahead of themselves coming out of last year’s brutal market.
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