by It turns out the Federal Reserve acted quickly and broke things, but few people noticed until the collapse of the Silicon Valley bank.
Over the past year, the Fed has been raising interest rates at an aggressive, rapid pace to curb high inflation in the United States. The common saying on Wall Street is that the Fed will hike rates until something breaks. Until last week, the question was what, if anything, broke. Rate hikes generally take time to work their way through the economy, but some people scratched their heads at how long that lag seemed to be. The job market, which the rate hikes are expected to cool, remained strong. The economy is generally in surprisingly decent shape. Sure, things were looking a little ugly in crypto and tech, but maybe the anger would be contained there.
Now the landscape is completely different, and we know what the Fed broke: the Silicon Valley Bank, or SVB. (Disclosure: Vox Media, which owns Vox, had a bank at SVB prior to its closure.)
It will be a long time before we understand exactly what happened in SVB’s rapid, stunning decline, but there is little doubt that rate hikes played a part. They were also likely involved in the demise of Silvergate and Signature Bank, both of which closed in March.
“It’s always a surprise. We didn’t know what was going to break, apparently that was it,” said Alexander Yokum, an analyst at CFRA Research who covers banks. “This wouldn’t have happened if interest rates hadn’t gone up so quickly and these portfolios hadn’t gone down so badly.”
If interest rates continue to rise rapidly, this could pose further problems for other banks. This puts the Fed in a bit of trouble – they want to curb persistently high inflation and also ensure financial stability. Both fronts look quite difficult.
“We don’t know what risks are around the corner and which institutions are less sound than we might have thought, especially if interest rates continue to rise,” said Morgan Ricks, professor of banking and finance at Vanderbilt University. “We have seen inflationary pressures [for February] that was a bit higher than expected and the Fed could end up between a rock and a hard place here.”
The scenario is also a stark reminder of what’s at stake in the Fed’s efforts to combat high prices and the potential rate hikes that are bound to impact the economy.
“The Fed wanted to do things until something broke, and for something to break. And the next problem is that 2 million people will lose their jobs as the unemployment rate rises,” said Mike Konczal, director of macroeconomic analysis at the Roosevelt Institute.
Raising interest rates can be a solid business for banks because it allows them to borrow more and make more money, but as the SVB has shown, there are risks for them too.
SVB’s demise was the result of a bank run after signs of trouble at the bank emerged in the second week of March. The bank — which in SVB’s case is primarily focused on technology, startups and venture capital — takes deposits from customers and invests them in generally safe-haven securities like bonds. Because the Fed has raised interest rates, these bonds are worth less. That wouldn’t normally be a problem – the SVB would just wait for those bonds to mature. But because venture capital and technology in general have slowed, in part because there is less free and cheap money floating around, deposit inflows have slowed and customers have started withdrawing their money. It became clear that SVB was in the midst of a liquidity crisis that triggered panic and ultimately bankrupted the bank.
The concern is that rate hikes could also threaten other banks. The more interest rates rise, the more banks could become a problem.
“The Fed’s rapid rate hike cycle is having a bigger impact on the US economy than I think many people at all levels realized just a few weeks ago,” said Josh Lipsky, senior director of the GeoEconomics Center at the Atlantic Council. “I think we can confidently say that interest rates in the economy are showing their teeth.”
However, the SVB had other peculiarities. It catered to a monolithic clientele, meaning it was heavily exposed to one industry, and if that industry faltered, so would it. It also held a large amount of uninsured deposits. Silvergate and Signature, which also collapsed, had dived into crypto, which was also struggling.
Megan Greene, Kroll’s global chief economist, said the uniqueness of these banks is worth considering, especially given the suggestion that it was all the result of the Fed tightening monetary conditions too much. “I would have more sympathy for this argument if Silicon Valley Bank and Silvergate weren’t so idiosyncratic,” she said. If central banks change conditions, “we will face further dislocations”. The SVB also made some real misjudgments about the potential impact of inflation rate hikes. “Uniquely, SVB has not hedged interest rate risk at all, which is just mind-blowing,” Greene said.
Still, the SVB is not a total outlier, and rate hikes threaten other banks too, especially when the Fed is so aggressive. “When interest rates go up, it pushes bond prices down, and any institutions that are on the wrong side can find themselves in a less healthy financial position than we might want,” Ricks said.
That rate hikes could be a problem for banks is now becoming a problem for the Fed because they don’t want to destroy the banking sector. Before the collapse of the SVB, many investors expected the central bank to keep pace with rate hikes when policymakers next met on March 21-22. As the Wall Street Journal notes, last week there was talk of whether the Fed would hike rates by a quarter of a percentage point like in February or half a percentage point like in December. Now that has changed – many investors, analysts and pundits believe they will slow it down or even stop it altogether.
“They absolutely should, also because they have already put on so much,” said Konczal. The economy could cool down a bit on its own anyway, “because everyone is a bit scared and terrified” because of the SVB.
“Now they’re in a position where they’re wandering [half a percentage point] the next meeting is fuel on fire,” John Fagan, former director of the Treasury Department’s market group, told Politico.
It’s a difficult situation. Inflation, while appearing to be declining, remains high. The consumer price index rose by 6 percent in February compared to the previous year.
Gustavo Schwenkler, associate professor of finance at Santa Clara University’s Leavey School of Business, said he doesn’t think the Fed’s overall goals of lowering inflation and cooling the economy have changed in the face of the SVB’s collapse. “The goals they have right now are a lot bigger than making sure the tech sector is doing well, but I definitely think they’re very concerned about how investors are going to react to their moves,” he said. “We may be hearing various types of communications from the Fed about what their next actions will be… to calm any uncertainty in this regard.”
On Sunday, after the FDIC, Treasury Department and Fed announced they would ensure all depositor funds were guaranteed by SVB and Signature Banks. The Fed also announced it would open a facility to provide funding to other financial institutions in the form of one-year loans. The aim is to try to limit contagion in the banking sector and stave off further bank runs, as was the case with SVB. It’s an attempt by the Fed to boost confidence so people don’t panic. Greene stressed that the Fed could both raise rates and open a new facility at the same time. “I don’t think this will change the Fed’s rate path at all,” she said.
Aside from what rate hikes mean for a handful of regional banks that may or may not find themselves in trouble, the SVB’s rapid collapse points to a larger problem: The Fed’s actions will have multiple implications for the economy. Some of these could cause great harm and surprise people.
“Everyone was wondering when something would break in the Fed’s rate-hiking cycle, and this was the first,” Konczal said. “This is just the beginning if they want to continue walking at the pace they are used to.”
Conventional economic wisdom says that fighting inflation requires raising interest rates to slow the economy, ultimately causing people to lose their jobs. The Fed has been fairly open that it expects the unemployment rate to rise. The firing or sacking of someone may not grab as many headlines as a bank collapse, but it is still disastrous for people’s individual lives and, when it happens more broadly, for the economy. Once the layoffs start, they’re hard to stop too, and the Fed can’t step in to empower workers like it must empower banks.
The horizon is not just a mood of doom. The economy could still have a soft landing without being pushed into recession, and the job market could perhaps slow without putting millions of people out of work. The SVB crisis could also prompt banks to tighten lending conditions and standards, meaning the Fed could decide to raise interest rates less than it thinks to meet its inflation-cutting goals, Donald said Kohn, former Fed Vice Chairman, in an email.
But for months there has been a feeling that something terrible could be lurking around the corner in the economy, although no one can say exactly what. The SVB’s demise is a reminder of how quickly the tide can turn and how unexpected it can be. In fighting inflation, that may not be the only thing the Fed breaks.
“It’s the nature of financial events to unfold quickly,” Ricks said. “No one can tell you for sure, no one can tell anyone for sure, that there isn’t another shoe here.”
