Those predicting a soft economic landing may be in for a rude awakening

Three of the four biggest bank failures in recent memory have occurred within the first five months of 2023. Thus far, three mid-sized banks (First Republic Bank, Silicon Valley Bank (SVB) and Signature Bank) and one crypto industry-focused financial institution, Silvergate Bank, have failed. Additional failures may be on the cards as concerns shift from the liability side of bank balance sheets to the asset side.

The Federal Reserve (Fed) appears to be nearing the end of the current rate-hike cycle. The target range for the federal funds rate was increased from 0.00-0.25 percent to 5.00-5.25 percent between March 2022 and May 2023. During the course of 10 consecutive rate hikes, which saw policy interest rates surge at a historically rapid clip, several financial institutions got caught on the wrong side of interest rate bets.

The massive fiscal stimulus injections during 2020-21, alongside the Fed’s extraordinary balance sheet expansion, created an enormous nationwide surge in bank deposits (as deposit growth far outpaced lending growth). Furthermore, given the sudden and explosive growth in account balances, it was not surprising that several banks ended up with sizable pools of uninsured deposits.

SVB’s travails were noteworthy given that the bank had bought supposedly safe long-dated government-backed securities (Treasuries and mortgage-backed securities). Top SVB officials had their multi-year bonuses tied to the bank’s return on equity (ROE), which incentivized the accumulation of relatively low-yielding (and thus high-priced) long-dated securities after the Fed forced short-term rates down to near-zero levels in 2020 and promised to keep them there for several years.

SVB officials were caught in a bind in 2022 as the Fed belatedly realized that it had fallen behind the curve and needed to raise rates quickly to cool inflation that had surged to 40-year highs. The sudden monetary regime shift caused a rapid repricing of long-term bonds — yields rose and prices fell quite sharply.

U.S. accounting rules allow for bonds designated as hold-to-maturity (HTM) to not be marked to market — unrealized gains/losses need not be recognized as long as the securities are not sold. Meanwhile, securities designated as available-for-sale (AFS) must be marked to market and reflect current paper losses/gains. When SVB’s relatively narrow client base (mostly consisting of Venture Capitalists (VCs) and the tech start-ups they backed) suddenly started to withdraw their deposits at a rapid clip, the bank was forced to liquidate some of its AFS security holdings at a sizable loss.

This caused investors and depositors to wonder what lay ahead. If deposit withdrawals were to force SVB to start selling its HTM holdings, accounting rules would force it to mark the entire HTM-designated security holdings to market value and recognize substantial paper losses. This could lower the value of the asset-side of the balance sheet to a level that wipes out bank equity and pushes the institution into technical insolvency. In the case of SVB, such fears were realized quickly — in the age of social media and instant communications, bank runs develop at lightning speed. 

While limitations associated with a narrow and fickle client base and failure to adequately protect against interest rate risk (via interest rate derivatives) played a central role in SVB’s demise, fears are growing that a wider swath of the financial system may be in danger as attention shifts from liquidity concerns to credit risks.

Regional banks with sizable exposure to the commercial real estate (CRE) sector may be particularly vulnerable. High office vacancy rates in key cities raise the specter of substantial loan defaults in the coming quarters. Furthermore, commercial mortgage-backed securities (CMBS) often have short maturities. Shifting financial conditions suggest that significant refinancing troubles may lie ahead.

Another area of concern is associated with the explosive growth of non-bank finance (and shadow banking). The International Monetary Fund recently warned that for non-bank financial intermediaries (NBFI), “vulnerabilities appear to have increased in the past decade.”

Years of low rates, volatility compression and ample liquidity supply by the G-4 central banks have laid the foundation for the current era of heightened financial instability. Raghuram Rajan recently observed: “Long periods of low interest rates and high liquidity prompt an increase in asset prices and associated leveraging. And both the government and the private sector leveraged up. Of course, the pandemic and Putin’s war pushed up government spending. But so did ultralow long-term interest rates and a bond market anesthetized by central bank actions such as quantitative easing.”

Expectations that decades-high inflation levels can be brought down (alongside an unwinding of more than a decade of monetary excess) without causing any major financial or economic turmoil requires a level of innate optimism that might border on delusional thinking. Those who still think that a soft-landing is the likeliest outcome may be in for a rude awakening. The stock market in particular may be mispricing near to medium term risks.

A recession is the likely outcome, and the possibility of a stagflation-lite scenario cannot be ruled out. But resilient consumers (aided by relatively strong household balance sheets and tight labor markets) offer a modicum of protection against the possibility of a deep or protracted recession. Limited fiscal space and sticky inflation may, however, restrict policymakers’ ability to offer sizable stimulus this time around.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.