Banking systems rest on fragile foundations, with a collective leverage ratio of 10 to 1
This means that only 10% of the liabilities (essentially deposits owned by the clients) are covered by the bank's equity
Stated otherwise, the trust each depositor will always be made whole, whatever happens, is of the essence to support each bank
Bank runs are self-fulfilling prophecies - only brought back under control by support of the collective banking system
But what if a myriad of negatives hits the banks collectively ?
And negatives abound....
A palatable sense of urgency to regain control over inflation...
A fast rise of interest rates forcing major losses on banks unfortunate enough to have to mark their assets to market (and take the losses on Treasuries, Mortgage-backed securities and such) to honor the withdrawal of deposits...
Lightning fast digital withdrawals and transfers (24/24/7) - experienced in real time by Silicon Valley Bank in a matter of days for $42 billion (a quarter of its deposits)
And - maybe worst of all - structural exposure of each and every regional bank to local economic downturns, with less of a 'liquidity' cushion to toughen it out
A perfect storm
Structural flaws
Laid bare by unequal access to liquidity, the flaws may in fact be hiding in broad daylight
The dubious 'too-big-to-fail' stamp of recognition, benefiting the global banks such as JP Morgan Chase
In America's fragmented landscape, some 80 smaller - usually very regional - banks coexist peacefully with the big banking beasts as long as liquidity flows unhampered through the complicated circuits of the monetary system
Liquidity is the life blood of any bank and customer deposits' low cost are the gold standard to finance the bank's lending operations
- Deposits have not vanished but with the ease of digital transfers, banking institutions believed to be more trustworthy (which the larger ones usually are) benefit at the first whiff of doubt
- What is more, and just as hard on smaller banks, better remunerated money market accounts are attractive alternatives for investors, transfering deposits outside the banking system - a fact made glaringly obvious by the Fed's well-advertised interest rate increases
Liquidity flight from regional banks is compounded by liquidity roll-back - affecting the entire banking system with a degree of liquidity scarcity, engineered by the Central Bank under the appellation of Quantitative Tightening (QT)
QT is the reverse of Quantitative Easing by which the Fed (and other Central Banks) flooded the banking system with liquidity during the financial crisis and time and again thereafter - that was then...
This is now...
- The Fed aims to bring the assets on its balance sheet (Treasuries and Mortgage-backed securities) back to normal, by selling assets over time and pulling liquidity back (out of the banking system)
As urgent as it may be to tamp the Federal Reserve's assets bubble down - if only to allow for another bout of liquidity (QE) in the future, nothing turns out to be straightforward
- The magnitude of the holdings - mirror image of the liquidity injected by the Fed - challenges any conceivable policy (or our imagination)
- From $4.2 trillion in December 2019, Fed assets topped $9.6 trillion in May 2022 before falling to $8.5 trillion in April 2023
As it turns out, injecting liquidity by way of assets acquisition is 'easy' because the monetary system will always know how to allocate cash streams - on the stock markets, in real estate etc...
Turning back the clock, withdrawing the liquidity by selling the Fed's assets back into the market, turns out to be very hard (as any drug addict surely knows)
Simply stated, the problem is that...
...the flight of bank deposits and the Fed's QT liquidity withdrawal affect the banks in blatantly very different ways - the small banks loose out on deposits and liquidity, the global banks win...
...all the while the Fed remains understandably reluctant to be drawn into guaranteeing the entire banking system
Something has to break
Monetary fiction and discomfort
The fiction is in the story line
- Inflation was going to be a temporary bout of fever
- Explained away by the economic supply shocks following the COVID downturn, and the energy crisis, inflation was linked to structural readjustments
- Tellingly, monetary inflation explained itself as a consequence - in price increases - of global supply chain misalignment
Good fiction always is true - in part at least
The bond market has been great for investors - and stayed great - for decades as interest rates seemed to be on an inexorable downward path
Even 100-year bonds and 'forever' bonds, issued by some companies and a few countries, attest of confidence in very long term monetary stability - discounting temporary and unavoidable hiccups
But when inconsistencies shake plausible narratives, doubts creep in
The US Federal Reserve's challenge is to show that monetary stability (at 2% inflation) remains the undisputable norm
This is because the entire price structure of the bond market hinges on this assumption - treated as fact, not fiction
US inflation at 8.54% last year in the US may - or may not - be a temporary blip but the pivot in the Fed's narrative is unmistakable
- Temporary structural inflation may have taken place of honor in last year's narrative - but not any longer...
- The Fed's QT and rate policy point to not-so-temporary monetary inflation - by tightening liquidity and constraining credit by way of higher interest rates
...surely much harder to rein in - and taking much longer too
Anticipations
It is just possible that by recognizing inflation's monetary origin, and by acting accordingly, the Fed has unwittingly lifted a corner of the veil shielding the bond market
From past experience, inflationary stress qualifies a self-fulfilling assumption - past inflation pushing salary raises and more inflation down the road
Times may be changing but it is far from a sure thing...
Glaring inconsistencies - zero (and even in some cases negative) yielding bonds and actual inflation rates - could pass muster under the force of habit
With inflation bounding to 8% - and interest rate playing catch-up - doubts may infect such a lenient bond market posture
And where to look for bond holders most exposed in case of radical repricing - forcing long term rates up and bond prices down - but in the banking system ...
Banks are allowed to value assets such as bonds at their face value so long as they declare that the plan is to hold them until they mature....
In the bond market, plain realignment of yield with expected future inflation rates (at 3%or more realistically at 4%) would imply large losses if assets were marked to market
... in normal times, long-term bank assets do not have to be sold but exposure of the regional banks to a triple whammy is too close for comfort
Times may not be normal after all...
- money market competition for deposits (wiping out the rate differential between cost of deposits and lending rates)
- digital transfers at lightning speed
- the weight of Quantitative Tightening falling on bank reserves - impacting to a greater extent regional banks with low and uncertain deposit acquisition rates
Short sellers of bank stocks are fingered in the general press as the guilty party for collective share price collapse
It may sometimes be true that the tail is wagging the dog....
...but rarely so