US authorities upend banking rules in haste to save SVB

Capital markets specialists are still struggling to understand the radical actions taken by the US financial authorities to stem the crisis of confidence started by the failure of Silicon Valley Bank, and believe they could have far-reaching implications.

On Sunday evening, the US Treasury, Federal Reserve and Federal Deposit Insurance Corp jointly announced they had decided to “fully protect” all the nearly $180bn of deposits at Silicon Valley Bank, which they had closed early on Friday morning — not just the insured deposits up to $250,000.

The same benefit, which the authorities called a “systemic risk exception”, was given to depositors at Signature Bank.

The Fed also opened its new Bank Term Funding Program, available for a year, under which it will lend to any bank for terms of up to a year against the par value of Treasury, agency and municipal bonds, instead of their discounted market value. The change also applies to repo lending through its usual discount window.

The purpose is clear: to ensure banks suffering from falls on bond portfolios do not have to sell them quickly at a loss if they need cash.

Both actions break precedent in ways that confer great advantages on some financial institutions and players, and change the structure of incentives that surround them and influence their behaviour.

From the vantage point of Tuesday, when bank shares and credit spreads were rallying again in Europe and the US, with steep jumps in some of the regional banks such as First Republic Bank that had been hammered in the previous few days, market participants’ instinct was to herald the measures as having worked.

“It’s over,” said the head of syndicate at a leading bank in London. “It was a storm in a teacup as usual. It was a bit ludicrous — I literally haven’t found a single person who thinks there was any contagion or read-across [to large and European banks]. I’m not sure why there was this reaction, and yet it happened. It was just a classic risk puke and an excuse to sell. If it wasn’t that it would have been something else. It’s just a bit more exciting than only having to talk about inflation.”

But he admitted: "It'll be rubbish again tomorrow, no doubt." His instinct turned out to be right, as European bank stocks plummeted on Wednesday amid fears that Credit Suisse might fail.

The turmoil dragged down the US market at Wednesday's open, after a much stronger Tuesday, when the US authorities' actions appeared to have been enough to quell panic about the US banks. “There is already some sense of stability coming back,” said Matt Cairns, head of credit strategy and regulation in Rabobank’s research team in London, on Tuesday. But he said Credit Suisse was "potentially the weak spot in Europe because it's certainly had and continues to have its challenges. If this were to continue to the point where we had a run on Credit Suisse, this is such a strategic asset for the Swiss economy that they would bail it out."

He thought the government would take an equity stake in it and keep the bank running, as the UK did with Royal Bank of Scotland in the financial crisis.

The measures announced by the US bodies on Sunday night had been “so massive”, said Nicolas Véron, senior fellow at Bruegel and the Peterson Institute for International Economics in Washington, on Tuesday, that he had been in little doubt they would work.

“There is no rational reason to run from any bank in the US, because deposits are fully guaranteed with no limit,” he said. “It makes no sense to run from a bank guaranteed by the US government.”

The joint statement by the three organs on Sunday only extended protection to the uninsured deposits of SVB and Signature Bank, but Véron said that in practice, because of the precedent it created, this meant all banks’ deposits would be guaranteed “not only now but forever. My jaw dropped when I saw the statement and I have been wearing black since. I thought the concept of a limited deposit guarantee was useful.”

In the US, only deposits up to $250,000 in any institution are meant to be guaranteed by the Federal Deposit Insurance Corp, which has a $128bn fund raised through a levy on banks. The UK’s Financial Services Compensation Scheme protects deposits up to £85,000, while in the EU they are covered up to €100,000.

The syndicate head drew the same conclusion, calling the change an “incredible thing”.

“Effectively you have moved now to a situation where there are no apparent limits to depositor insurance schemes,” he said. “It means [the public] have to pay for it because it comes out of what banks contributed to the FDIC fund. If you have money in some poxy entity in the UK because they’re offering a higher rate than HSBC then are you not going to be capped at £85,000? I think £85,000 should be enough to cover all the vulnerable people. I’m not sure why the FDIC went to those lengths, especially as a ton of the deposits weren’t retail deposits.”

The banks — and hence their customers and shareholders — that contributed to the FDIC fund expected this to be used for small deposits.

Asked whether a similar blanket deposit guarantee had been given before, Véron said: “In Ireland in 2008 it was done, to give just one example. Many of us thought the US had a better system and was able to preserve it. I characterised it on the spot as regime change and I’m not revising that judgement at this point.”

He was puzzled by how such a momentous change in financial policy had been decided on. The people involved, such as treasury secretary Janet Yellen, Fed chair Jerome Powell and Martin Gruenberg, chairman of the FDIC, were veterans. “Normally people who have been through crises are less likely to make a misguided decision out of panic,” he said.

Véron said it was not possible to know yet how the decision had been made or what implications had been considered, but his “working assumption… is it was a properly considered political decision. This is a full bailout of Silicon Valley in general. Because Silicon Valley is important and has many dimensions in the life of the nation, there are many ways to explain it. But the decision was not motivated by considerations of financial stability.”

Admitting that outsiders did not have access to all the facts the regulators had, Véron said his interpretation was SVB had been saved because of the damage its failure would have caused to the many tech companies and venture capital funds that had stored collectively billions of dollars in cash deposits at the bank.

SVB going down was not likely to cause systemic damage to the US banking system, but would have caused “a very disruptive crash” in the US’s tech sector, Véron said, “with lots of start-ups failing, lots of people losing their jobs, lots of tax revenue disappearing for California.”

These reasons may have convinced politicians, he said, to make “a bailout of SVB for reasons that may have been good — but the instrument doesn’t look good for me, because it destroys the system of incentives that existed basically only in the US system”.

In fact, whatever the rules say, there is limited precedent for uninsured deposits actually being lost in bank failures in the US or Europe.

It had happened in the US before the 2008 financial crisis and partially with the failure of IndyMac Bank during the crisis, but Véron said “the vast majority” of bank failures in the US had been resolved by a stronger bank buying the weak one and all the deposits being kept whole.

In Europe, “Nobody believes [this risk]. Banks are bailed out and depositors don’t lose money,” Véron said. The only exceptions in recent years had been a few very small banks in Denmark.

In 2013 the EU authorities imposed partial losses on depositors of over €100,000 in Cyprus’s banks in return for a €10bn bailout of the country, but that was a painful experience that involved the country imposing capital controls, and is not seen as a template to be copied.

Despite the rarity of uninsured deposits being lost, Véron argued, the fear that they could be had remained in the US — until last weekend.

“I think the distinction mattered to financial stability,” he said. “I think we will see banks competing for deposits with less discipline than before. We will see corporate treasurers applying less discipline to where they place deposits.”

Economists have long argued that the very fragility of short term debt is useful in disciplining the managers of banks, as Hyun Song Shin, now head of research at the Bank for International Settlements, explained in an article on the 2007 failure of the UK’s Northern Rock. “When the bank has the right quantity of deposits outstanding, any attempt by the banker to extort a rent from depositors will be met by a run, which drives the banker’s rents to zero,” said Shin. “Foreseeing this, the banker will not attempt to extort rents.”

If this fear is taken away because deposits are protected, corporate depositors will have no reason to be prudent about which banks they lend to, and banks will have less reason to be careful what risks they take.

Such a nonchalant attitude seems to have prevailed among the tech companies that deposited large sums with SVB. Unlimited deposit protection could make this the norm.

An atmosphere like that would be in stark contrast to the hawkish monitoring of bank risk that blue chip companies with billions of cash described to GlobalCapital in 2011, soon after the financial crisis. Firms such as Sanofi, KPN and Holcim watched banks’ credit default swap spreads and moved money between them immediately if one seemed to be becoming more risky — even though the banks involved were often large institutions.

Rather than a total guarantee of deposits, the syndicate head said, “there should be regulations in place that say ‘the bank is safe and you’ll get your money, but if everyone asks for their money at once the bank will go down’.”

Deposit withdrawals should be controlled until calm is restored, he argued.

The Fed’s new repo arrangements have received less attention, and capital market participants are still not sure quite how they work or what the effects will be.

The syndicate head called it “very generous to banks” but added “from what I understood it has to be for a specific reason”.

He thought the Fed would not make this facility available indiscriminately to all banks, but only to those in need, perhaps privately.

However, help offered only to banks in difficulty would be a red light signalling impairment and might fail to restore confidence. Many measures taken by central banks during the financial crisis and Covid pandemic were offered to the banking sector as a whole for this reason.

On the new Bank Term Funding Program, the Fed has clearly stated that any bank, credit union or savings association normally eligible to borrow from it can use the programme, and sets no limit on the quantity or circumstances. The only condition is that the borrower must have already owned the collateral on March 12, 2023.

US branches of foreign institutions are admitted. No fees apply and the loans are repayable early without penalty. Loans of up to one year will be made at 10bp over the one year overnight index swap rate, fixed on the day the advance is made. On Tuesday, the Fed’s website proclaimed in large figures that the rate was 4.68%.

The Fed also on Sunday extended the same benefit of being able to borrow against the par value of collateral to its ordinary discount window. Originally very short term, ‘primary credit’ at this window, the main type, was made more liberal in March 2020 to allow loans of up to 90 days. They are charged at the primary credit rate, currently 4.75%.

“This is a ‘whatever it takes’ approach, because it is free money and a free stop-gap,” said Cairns at Rabobank. “In theory, it should stem the rout. Give it a couple of days, and if there are no other skeletons in the closet, the market is going to take a lot of [its losses] back.”

The authorities’ thinking, he said, had been: “‘For 12 months this is yours, in the hope that 12 months is long enough for us to address this crisis.’ That kind of response I don’t think was cobbled together in a 12 hour window over the weekend. I get the sense that it has been sitting there [as a prepared tool] and lying in wait.”

But Cairns said he had not heard of par repo lending before as a theoretical weapon in central banks’ armouries.

In his analysis of the collapse of Overend, Gurney & Co in 1866 — the UK’s last full scale bank run before Northern Rock — Walter Bagehot is often cited as having formulated the dictum that central banks should lend freely, at high rates, to solvent institutions against good collateral.

In modern central banking, to ensure that collateral is “good”, loans are made against the market value of government bonds or other well rated notes such as US agency bonds or MBS.

Véron said lending against market value was “a general principle that has always been invoked but not always followed.”

He said the obvious case of a breach was Cyprus, where “uncollateralised emergency liquidity” loans had been privately given by the central bank, “which is by the book a contradiction” of principle.

Besides the repo changes’ long term effects on risk management and appetite, they could distort markets in the short term, too.

There would appear to be a strong temptation for banks to take maximum advantage of the new, more generous repos. They can only use collateral they already owned on March 12. It is not clear whether that includes securities already pledged as repo collateral, but if it does, they would be incentivised to pull bonds out of the old contracts and pledge them for new ones.

The Fed publishes data on use of its discount window with a two year lag. The most recent figures, for the fourth quarter of 2020, show total loans of $35.6bn to banks that borrowed during the period, but they had collateral with a total lendable value of $494bn.

“There is a very strong precedent we have seen over the last 12-13 years from central banks’ policy responses to financial crises,” said Cairns, that they “quite openly created distortions in the market, which have offered arbitrage opportunities to the institutions they are rescuing. I don’t think this time is any different.”

“The Fed has punched a big hole in its collateral framework,” said Véron.

But although this set a precedent, he argued, “Deposit insurance is mass business, repo is specialised business. It doesn’t create the same irreversibility in public perception. Maybe I’m naïve, but I would say if in future the Fed wants to apply its collateral policy without doing this, they can. If in future they want to impose losses on uninsured deposits, I’m not sure they can.”

Although the Fed had protected uninsured deposits during the financial crisis, and rescinded this in 2012, that did not necessarily mean it would be able to undo the policy this time, Véron said.

The difference was that in 2008 the US had been facing “general systemic turmoil. Friday last week doesn’t qualify as general systemic turmoil. They have lowered the bar” for protecting deposits, he added.

He thought the SVB crisis could have been stopped with just the repo action and no deposit guarantee, or even with something less strong than the unlimited repos.

That cannot now be known, as the Fed and Treasury reached straight for the big guns.

“Unfortunately, the markets now are just built in a way, or have ended up in a way where they can’t cope with these events,” said the syndicate head. “It’s the mismatch between the sheer size of these markets and dealers’ ability to take care of risk. The combination of all the electronic and algorithmic trading is that they overshoot — then everyone is trying to leave through the same exit. The markets are too big and the circuit breakers are not enough. We’re finding that with each new crisis — there are having to be additional extraordinary measures just to deal with it.”