Banking Stress

The closure of the Silicon Valley Bank (SVB) in March in the United States due to a run on deposits, threw a wrench in the gears of the banking system, exposing its weakest links. Regional US institutions immediately came under pressure, with First Republic standing out, partly due to the large amount of uninsured deposits.

The embattled lender disclosed massive deposit outflows for the first quarter of the year and regulators stepped in this week, facilitating its acquisition by banking giant JP Morgan Chase ^[1]. This does not seem to have eased concerns though, since on Thursday another regional institution faced intense pressure. The price of PacWest's (PACW.us) stock halved yesterday, as it continues to explore "strategic asset sales". ^[2]

The SPDR S&P Regional Banking ETF (KRE.us) shed nearly 30% of its value in March as the turmoil unfolded and loses another 15% this week, as fears over regional lenders flared up again.

The banking rout was not contained within the United States though, but spilled over to Europe as well. Credit Suisse sold off after the SVB failure due to a series of factors and eventually domestic rival UBS agreed to take it over, with the blessing of the authorities. ^[3]

ECB-Fed Divergent Response

The US Federal Reserve and the European Central Banks have both initiated an aggressive rate hiking cycle last year, in order to fight surging inflation that persists and the effort continues into 2023. However, the two central banks adopted two opposing approaches in the wake of these events, as the ECB stayed the course, whereas its US peer was forced into a more reserved stance.

After the SVB collapse, European policymakers did not budge and delivered another outsized 0.5% rate hike, while Ms Lagarde had hinted to more moves ahead. More to it, as I had pointed out then, Ms Lagarde drew a "clear distinction" between financial stability and price stability, meaning that monetary policy won't be dictated by the banking rout. ^[4]

Before those events unfolded, the Fed was looking poised to reaccelerate the pace of its rate-hiking cycle, but was eventually constrained to a reserved approach, expecting the turmoil to create credit tightening that would weigh on inflation and economic activity. Highlighting the opposing stance, Chair Powell had equated the credit tightening with a rate hike or even more, which would do some of Fed's work for it. ^[5]

This week's latest policy decisions by the two major central banks, right as the financial stress persists, showed that they continue to drift apart.

ECB Pointed to More Hikes

Even though the latest Euro Area Bank Lending Survey (BLS) revealed tighter conditions for loans and credit lines in the first quarter ^[6], the ECB delivered a rate increase of a quarter percentage point, in light of the "ongoing high inflation pressures".

Although this marked a slowdown in the pace of firming and the smallest hike since the July 2022 lift-off, policymakers pointed to more moves ahead, saying that future decisions "will ensure" a sufficiently restrictive level to bring inflation back down to 2%.

President Lagarde did not leave any doubt about the bank's resolve and succinctly declared that "we are not pausing, that's very clear", adding that "we have more ground to cover". ^[7]

Fed Pause Hint

The US Federal Reserve also raised rates by 25 basis points, to 5.00-5.25%, but this is one of the very few similarities. Despite persistent inflation and tight labor market, officials removed the prior guidance for "some additional policy firming", opening the door to a pause.

This "meaningful change", according to Chair Powell, suggests that the terminal rate has likely been achieved, with him expressing the feeling that they are "getting close or maybe even there". ^[8]