Fed walking a financial stability ‘tightrope’

US regulators are walking a tightrope in their use of the “systemic risk exception” for deposit insurance, several academics tell Central Banking.

The Federal Reserve and the Federal Deposit Insurance Corporation can use the exception when they judge a bank failure potentially threatens the entire banking system. When it invokes the exception, the FDIC insures 100% of the bank’s deposits, far above the usual $250,000 limit for each deposit.

Experts disagree over whether the Fed and FDIC’s reaction to recent bank failures was necessary to preserve stability or created a dangerous moral hazard.

On March 12, the Fed and the FDIC announced they would back up all uninsured deposits at SVB and Signature Bank. Some academics have criticised this move for encouraging businesses to adopt risky deposit behaviour. Others have said it creates the appearance some banking firms are too big to fail.

Thorsten Beck, director of the Florence School of Banking and Finance in Italy, argues the use of the exception creates a moral hazard.

“I can see the argument for [the exception], but I am not convinced this was the right approach,” says Beck, “as it creates significant moral hazard going forward as well as pressure to expand this to the rest of the banking system and possibly beyond.”

But other academics agree with the Fed and the FDIC. “They really had no choice,” says Greg Feldberg, director of research at the Yale Program on Financial Stability. It was appropriate, he says, “because they recognised right away that the toxic combination of uninsured deposit concentration and mark-to-market losses could be widespread. They tried to reassure folks.”

Victoria Ivashina, professor of finance at Harvard Business School, concurs, adding the context and the stakes are what make the exception appropriate. “The continuous focus of policy-makers has been on controlling inflation and doing so without triggering a deep recession or, ideally, no recession at all,” she says. “This is a pivotal long-lasting macroeconomic goal that connects to everything else, financial stability included.”

Today, she says, the problems with banks’ asset holdings are transparent, unlike in the 2008 financial crisis. Despite transparency within the banks, there are still unclear issues related to market behaviour. “The key unknown is the runnability of uninsured deposits,” she says.

“It is not about the number of banks, it is about what these banks have in common,” says Ivashina. In 2008, failing US banks shared exposure to subprime mortgages, she tells Central Banking.

“At the same time, we had very little visibility into the exposure of individual banks and their ability to withstand these shocks. What we see today is very different,” says Ivashina. “The fundamental fragility of banks that comes from combining uninsured deposits and loans is aggravated by the losses on the fixed income assets held by the banks, including Treasuries and mortgages.”

She says SVB and Signature Bank are unrepresentative of the banking industry, but more recent bank troubles may indicate bigger risks. “First Republic and last week’s stock tumble for several regional banks is a bigger concern,” she argues. “This is our window into how runnable deposits can be, now that money-market funds are fixed and rates are high.”

Beck notes: “It seems that as of now this is limited to regional banks with a certain business model.”

Feldberg says the banking failures pose widespread risk, not just regional. “There’s no doubt that this is a systemic situation,” he says, noting the market may have picked off the most vulnerable banks. But he thinks there will likely be more bank failures from banks that hold large sums of uninsured deposits.

Central banks are essentially trying to tighten credit conditions without causing a recession, he says. “It’s a very delicate game that the central banks are in.”

Credit conditions going forward

Bank failures and mergers affect credit conditions in the US. Less credit may jeopardise liquidity in the banking system, but it may also help the Fed fight inflation. Fed chair Jerome Powell estimated the recent bank failures could roughly affect the economy in the same way as one 25 basis point interest rate hike.

Ivashina says there is a case to be made that tightening credit and recent bank failures are a danger to the regional banking ecosystem. “The key unknown is whether depositors will continue leaving the banking sectors, and regional banks in particular,” she says. “There’s some small probability that could be the case and it would have further impact on credit. However, consequences of the banking failures to date are relatively contained.”

But she argues the more likely case is that tightening credit conditions will assist the Fed in lowering inflation. “While contraction in credit is anticipated, let’s not forget that the Fed has been trying to slow the economy by raising rates. So, it’s not all bad, as this is in line with the policy actions so far, acting as a substitute to the increase in rates,” Ivashina says. “Moreover, the fundamentals of the US economy remain very strong.”

Feldberg warns the US banking sector is likely to experience further trouble. “There’s been a lot of talk that we’re seeing the bad news coming soon on commercial real estate which is a delayed reaction after Covid. There’s a lot of concern about those types of losses coming in,” he says. “I think we’re still in the first phase of this.”

The next phase will depend on how long the Fed keeps its policy rate elevated. “The longer it keeps them up, the bigger the earnings that will be lost across the system,” he says. “So, you’re going to have a combination of the earnings hole and the realisation of credit risk that we’ve been expecting for some time.”

The delay between the implementation and the implications of monetary policy, says Feldberg, is what makes a central banker’s job difficult.

“You can say it was risky of them to continue raising rates after these bank failures,” he says. “But they would have lost the momentum on inflation fighting at a time when inflation is still elevated.”