Big Troubles at Little Banks: Time to Fear a 2008 Banking Crisis Redux?

In recent days we saw U.S. regulators take control of nearly USD $175 billion of Silicon Valley Bank’s (SVB) assets and deployed measures to contain the crisis, making this the largest institutional failure since the financial crisis of 2008. Another little U.S. bank (Signature Bank) also collapsed shortly after, thereby sparking concerns of contagion and stability of the U.S. financial system (Source: Reuters). This seismic shock was severe enough to negatively impact Canadian banks and their global peers. Unlike 2008 where bad loans were responsible for the subprime crisis, the ongoing crisis around SVB and other little, regional banks is more about an old-fashioned liquidity crisis and bank run, amplified by bad management, especially around the management of interest-rate risk.

In contrast to little banks (measured by assets), large U.S. banks are subject to tight regulatory oversight. The balance sheet of large banks must meet strict criteria designed to help shield them against a sudden, unexpected demand for cash (a.k.a. a bank run) by maintaining high capital ratios of high-quality, liquid assets (HQLA), alongside proper risk-management practices to ensure that their assets would be available in case of market stress.

Overall, we think the on-going events around U.S. regional banks are more a sporadic crisis of confidence about the U.S financial system rather than the canary in the coal mine signaling an upcoming banking crisis. In reaction to the distress at little banks, large U.S. banks have attracted billions of new assets in recent days as depositors seek to park their money at sound, and more regulated banking institutions. One of the important lessons of the great financial crisis of 2008-09 has been to make the banking system more resilient to macro-economic stress by ensuring that large financial institutions can sustain macro-economic stress: recessions are rare, but they happen every once in a while, and are a natural part of the economic cycle. Meanwhile, it’s also natural to see bad businesses going down, but markets are always more nervous when they see distress at a financial institution, even when it’s a little one. A similar episode of market stress happened in Canada back in 2017 when Home Capital endured a bank run, dragging with it the entire banking sector of the TSX (Source: CBC).

Implications for economic outlook

Unless several other little banks go under into the summer, the risk of a large economic shock from the fallout of a couple regional banks remain low, in our view. Because little banks play a big role at financing small and medium sized firms, we expect credit growth to continue cooling into the summer as little banks seek to strengthen their balance sheet with capital. Overall, however, this does not materially alter our outlook of the U.S. economy as the slowdown in economic activity in 2023 remains widely expected, although it has yet to translate into a contracting economy and rising unemployment.

Ultimately, what differentiates the severity of an economic cycle and recessions is what happens to the job market. We think labour shortages are becoming more secular than cyclical and will persist into 2024, which means that we do not expect mass layoffs to hit the economy in a way that would send the unemployment rate rising by multiple percentage points and cause a surge in default, thereby delivering a severe recession. We remain in the camp of a mild recession and even see low but rising odds that Canada and the U.S. could avoid the recession, though they could still face a below-trend growth environment.

Implications for monetary policy and fixed income

Monetary policy has played a pivotal role for financial markets in the past eighteen months and the sudden rise of systemic risk that shook markets is a good reminder of how important the Fed and central bank actions are for financial markets. For fixed-income markets, the impact in the repricing of expectations was most spectacular for the 2-year bond yields of U.S. and Canadian Federal debt, the most sensitive part of the yield curve to monetary policy, as yields fell a cumulative 129 and 82 basis points between March 9 to March 15th, respectively. Not only odds of future rate hikes were shaved, but the timing of rate cuts was also brought forward into 2023, perhaps starting within a few months.

For investors that were worried about seeing 6% policy rates in 2023, we think an optimistic scenario will be hard to realize as financial strains are brewing in parts of the economy. Reducing the odds of 6% policy rates is good news for fixed-income investors after a uniquely challenging 2022. A key takeaway from the recent bond-market reaction is that central banks will eventually have to normalize and ease policy. By contrast to pro-cyclically hiking into a slowing economy in 2022, slow economic growth over coming quarters should eventually force central banks to resume their counter-cyclical policy actions and ease policy to support growth. For 60-40 type investors, this means their equity portfolios are not only better diversified by the buffer of higher interest rates, but they are also potentially better cushioned by the scope of falling interest rates in the event of an economic slowdown that would require rate cuts.

Implications for asset allocation

Markets have been choppy in recent trading sessions, and while regional banks, the epicentre of the crisis, remain underwater this month, the broader market appears better positioned to navigate this period of uncertainty as the economy continues to perform well, even delaying calls for a recession to later in 2023 or even to 2024.

For larger banks and financials, we think they could be a buying opportunity in the near-term as markets tend to exaggerate their reaction when spectacular events suddenly happen, whether it’s a global pandemic or the downfall of a little bank. But we suspect it will take some time for markets to move beyond the fear that the Fed has hiked too quickly, too far and broke something, again. Our portfolios remain cautiously positioned as uncertainty remains elevated.