Banking Rout

The current turmoil in the financial sector started in the US and the run on Silicon Valley Bank, after a $1.8 hole by the sale of a losing security portfolio, as prices of government bonds have slumped under the Fed's aggressive monetary tightening. ^[1]

The situation however quickly spilled-over to the Signature Bank of New York, while regional banks such as First Republic started to feel the heat. As fear set in, the turmoil spread to Europe, with the weakest links coming under pressure.

Credit Suisse emerged as the next liability, as it has been in trouble since at least the 2021 and the Archegos-related losses, having recently announced a restructuring plan, in an effort to turn things around. Its stock collapsed last Wednesday, after the Saudi National Bank refused to raise its stake to assuage liquidity concerns, according to Reuters. ^[2]

Containment Efforts

Authorities in the US took quick action to close Silicon Valley Bank ^[3]and Signature Bank ^[4] and guarantee deposits, to avoid further strain into the financial system. More to it, the US Federal Reserve launched a new Bank Term Funding Program (BTFP) to offer loans to banks and financial institutions. ^[5]

According to data released late last week, banks borrowed nearly $12 billion under the BTFP scheme as of March 15, with loans totaling around $300 billion overall ^[6]. Furthermore, a group of banking heavyweights such as JP Morgan Chase and Citigroup offered help to the First Republic Bank, with $30 billion in uninsured deposits. ^[7]

On Sunday, six major central banks, including the US Fed and the ECB, took coordinated action to shield the financial system, agreeing to "enhance the provision of liquidity" via the standing U.S. dollar liquidity swap line arrangements. ^[8]

UBS Agrees to Buy Credit Suisse

Meanwhile authorities in Switzerland scrambled to contain the Credit Suisse situation, before markets opened this Monday, with their efforts bearing fruit. Banking giant UBS agreed to acquire the troubled institution, for CHF 3 billion (around 3.2 billion USD). ^[9]

This deal came with the blessing of the Swiss National Bank (SNB), which spoke of a solution "to secure financial stability and protect the Swiss economy" and pledged CHF100 billion to support it ^[9]. The agreement also had the backing of the government, since it granted a guarantee of CHF 9 billion to "reduce any risks" for UBS. ^[10]

It now remains to be seen if the deal will assuage market fears, but it does look a bit messy, while FINMA's decision to write-off CHF15.8 billion of Credit Suisse's AT1 (Additional Tier 1) debt, appears to have has created unrest amongst those bondholders. ^[11]

All Eyes on the US Fed

Against this highly fluid and uncertain backdrop and as events were unfolding, the European Central bank (ECB) did not blink on Thursday and stayed the course with another 50 basis points rate increase, in what constitutes a vote of confidence to a certain extent. Ms Lagarde noted that the ECB "a lot more ground to cover" on the tightening situation, but refrained from offering any forward guidance. ^[12]

Focus now shifts to the US Fed which is caught between a rock and a hard, as it will be handing over its latest policy decision on Wednesday March 22. Policymakers have been slowing the pace of tightening, but have maintained a very aggressive stance, amidst sticky inflation and tight labor market.

However, the recent banking rout has thrown everything up in the air, since it pulls policy to a different direction. Officials will have to balance between their pledge to bring inflation down by tightening, while risk to the financial system calls for a more conservative approach.

These developments have also caused volatility and repricings in markets expectation around the Fed's next move, with CME's FedWatch Tool showing roughly split chances between a 50 bps increase and a hold, at the time of writing. ^[13]

To a certain extent, a hike could be viewed as contradictory to the recent pumping of liquidity and policy officials may opt to shift focus away from inflation, at least for the time being. On the other hand, a pause may send the wrong signal to markets, around the Fed's confidence in the financial system.