The banking crisis, which originated from the collapse of Silicon Valley Bank, is rapidly spreading and causing widespread market panic. Despite the Swiss regulator's attempt to alleviate the situation through the flash takeover of Credit Suisse by UBS on March 19, the panic has not been reduced. The banking industry is still grappling with a challenging environment as the substantial discount on Credit Suisse shares and the full write-down of TIA 1 bonds in the Credit Suisse acquisition has raised concerns about the risk of debt and equity investments in the banking sector.
On March 20, First Republic Bank, which has become the focal point of market attention, experienced a drastic decline of 47.11% in its share price, hitting a historic low. Its stock has been shrinking by over 90% since March 3 and triggered the meltdown mechanism several times throughout the day. The S&P rating agency downgraded First Republic Bank's stock to "junk," stating that the recent USD 30 billion deposit injection from 11 major banks may not be sufficient to solve the bank's liquidity problems. Credit Suisse experienced a dip of over 55% at one point, and UBS shares fell by 12% before rebounding. Meanwhile, CDS prices indicate that Deutsche Bank, Germany's largest commercial bank, could be the next European bank at risk. Sheila Bair, former chairman of the FDIC, warned that the U.S. banking system is now experiencing a "Bear Stearns moment," as market panic surrounding the banking system continues to spread and uncertainty increases. If the government fails to provide continued support, U.S. banks might fall like dominoes.
The banking crisis has multiple root causes, including banks' own operational defects and the Federal Reserve's tightening of monetary policy, resulting in a "high interest rate, high inflation" environment, which has been identified as the primary driver of the financial system's growing vulnerability. According to FDIC data, U.S. banks' total book loss from bond holdings is expected to surge to around USD 620 billion by the end of 2022, further exacerbating the financial system's vulnerability. Under the pressure of tightening liquidity, banks are being forced to sell their bond holdings, resulting in the realization of floating losses as real losses. This problem is compounded by the Fed's aggressive interest rate hikes, which have undermined the perceived safety of U.S. bonds as "safe-haven assets”. Researchers at ANBOUND have previously identified high inflation and interest rates as a symptom of systemic problems in the banking industry, rather than just a liquidity risk issue. Central banks such as those in the U.S. and Switzerland have attempted to offer liquidity support, but these measures have not been sufficient to stop the continued problems of the troubled banks without actual changes in monetary policies.
Therefore, the market is now calling other than for financial regulators to bail out banks in crisis, the Fed needs to stop raising interest rates. Some have even asked the Fed to change its monetary policy and implement mass easing again. Although the Fed has taken some tools to provide additional liquidity to the market, such as expanding its balance sheet by about USD 300 billion last week, it is unclear whether it will continue its planned quantitative tightening (QT) policy. The Fed has not shown any signs of slowing down its rate hikes, which could increase the likelihood of financial risk contagion and systemic risk. After the ECB raised interest rates by 50 basis points as planned, Credit Suisse's asset position sharply deteriorated, ultimately leading to its acquisition. The Fed's policy decision choices too will be critical in determining the pace of the spread of financial risk and its possible impact on the banking system.
According to ANBOUND researchers, the current banking crisis has created uncertainty around the monetary policies of central banks in Europe and the U.S. As a result, Fed is faced with a difficult choice if it continues to raise interest rates may cause more banks to collapse and could lead to market panic, while stopping the rate hikes could exacerbate inflation and lead to economic contraction. This dilemma is a direct result of the banking crisis.
The most prudent approach for the Fed would be to take a middle ground and avoid any radical policies. This would involve raising interest rates by 25 basis points to maintain a balance between inflation and financial risk. In the past, the market had expected a more aggressive approach of a 50 basis point rate hike when inflation was high, but this could now lead to a sharp deterioration in banking risks. At the same time, it must also avoid being indifferent to inflation and further exacerbating economic imbalances. Market participants are worried that if the Fed stops raising interest rates too quickly, it could lead to uncontrollable financial risks and intensify the market panic. In this dilemma, taking a middle ground and prudent choices is also the expectation of the majority of market participants. Recently, Allianz's chief economic adviser Mohamed El-Erian also called on the Fed to raise interest rates by 25 basis points at the March meeting.
The risks spreading throughout the U.S. banking sector are likely to cause a rapid decline in demand for the U.S. economy, resulting in lower inflation levels. This outcome is actually beneficial for the Fed's monetary policy, as it avoids the dilemma of choosing between inflation and employment objectives. However, this approach may also accelerate the decline of the U.S. economy, potentially leading to a hard landing. Nonetheless, for the Fed, this is a better outcome than a financial tsunami caused by a loss of control over banking risks. In the long run, the Fed's policy path and cycle are likely to change.
Final analysis conclusion:
The banking crisis caused by the collapse of Silicon Valley Bank continues to spread, and the Federal Reserve's decision at the March monetary policy meeting will have a significant impact on the future direction of the U.S. economy, as well as on the current pace of financial risk development and contagion. In the midst of this dilemma, the better choice for the Fed is still to take a middle ground approach to avoid an imbalance between short-term and long-term crises.
