What's Next for the Fed and for Banking Regulation?

Federal Reserve - Shutterstock photo
Credit: Shutterstock photo

Runs on banks, and bank crises, are rarely logical. They are about an erosion of confidence, itself an intangible and illogical thing that leads to panic, the most illogical among emotions. It should come as no surprise that the problems at Silicon Valley Bank at the end of last week and the hint of contagion that we are seeing this morning are illogical. However, that doesn’t make those things less real, and the question for investors at this point is will this be powerful enough to force changes to the regulatory environment, or to make the Fed pause the rate hikes?

First off, this is a “crisis” based on the observation of something that has been in plain sight: Confidence in Silicon Valley Bank seems to have eroded when somebody realized that bonds, which inevitably represented a big chunk of the bank’s reserves, had fallen in price and market value as interest rates had risen. In other breaking news, I can confirm that the Pope is indeed Catholic, that bears do relieve themselves in wooded areas, and that Lichtenstein is actually quite small.

Sarcasm aside though, if investors and depositors are shocked enough by that to make wholesale withdrawals from any bank, it does present the Fed with a problem, because that simple market dynamic doesn’t just affect SVB. Nor, if it is seen as a problem, is it just a problem for tech-focused or regional banks. Every bank holds Treasuries that will have declined in value as rates have risen. That is why the central bank and the Treasury Department have fallen over themselves to move remarkably quickly for federal institutions and essentially guarantee that all depositors at SVB and other impacted institutions will be made whole.

That strengthens the argument to raise the completely outdated $250,000 limit to FDIC insurance, but more importantly there is a moral hazard here that echoes what people were worried about after the bailouts that followed the 2008 recession. If the feds will always step in and bail out a bank in trouble, what is to stop banks taking on excessive risk in the future? After all, stories are already being bandied about this time, just as they were fifteen years ago, of bonuses being paid and stock being sold so that the individuals here didn’t suffer too much. Those stories may or may not be true, but just their presence will make risk seem a lot less risky for others in the future.

The answer back then was the Dodd-Frank Act, which imposed restrictions and regulations on banks and other financial institutions, in part to protect against that moral hazard. Some parts of that law were seen as too restrictive by a lot of people and were repealed in 2018. However, the events of the last few days suggest that Senator Dodd and Congressman Frank were right after all. If financial stability depends on an assumption that there is a federal backstop, the activities of banks have to be heavily regulated to make the use of that backstop less likely. As unsavory as that idea may be to free market types, the two alternatives -- periodic collapses of the entire financial system or complete nationalization of the banking industry -- are probably even less appealing.

The impact of the affair on monetary policy is a little harder to estimate in some ways, because the Fed could go either way. The Fed has shown itself to be sensitive to market conditions and sentiment, but have recently started to trumpet their resolve in the fight against inflation. Can they now turn around and say “Oh, things have gotten tough, so we are changing our minds again”? I don’t think so.

The most likely course seems to be that the Fed talks out of both sides of their mouth. They will ease financial conditions for a while, offering easy money to restore faith in the liquidity of the banking system, while simultaneously continuing to try to slow the economy by raising interest rates. The next hike will probably be by the minimum of 25 basis points and come with a carefully worded statement about understanding the impact of policy on banks’ liquidity.

Seen together, that is contradictory and a bit silly, but each policy has a specific purpose. Easy credit in the system is about creating an impression, while rate hikes are about having a material impact on growth. Looked at in that way, doing both at the same time actually does make sense.

For those who find this all too depressing, that one bank’s liquidity issues seem to necessitate a big governmental response, there is also a free market dynamic taking place that will help to alleviate the pressure on the banking system: As fear has risen, so people have bought Treasuries in a flight to safety. That has pushed yields along the curve down substantially, raising the value of banks’ bond holdings. Ah, the beauty of markets.

I still maintain, as I said on Friday, that logically, this should be a contained problem. The rapid response by the Fed and the Treasury to protect depositors at SVB, and now at other impacted institutions, will have made that even more likely. But there will be consequences that result from that. There is a good chance that bank regulations will be tightened again, and the Fed will be operating for a while in an environment where one policy counteracts another, thus delaying the fight against inflation. Now all we need is for everyone to understand that and behave logically from here on out.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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