The recent banking turmoil that occurred with SVB Financial and Credit Suisse caused concern among many people who were reminded of the financial crisis of 2008-09. The two events are vastly different as the problem involves a handful of banks rather than extending to a systemic banking crisis. Moreover, the 2008-09 financial crisis centered on aggressive lending practices and toxic assets held on bank balance sheets, whereas the current issue relates to bank liquidity in the face of sudden deposit withdrawals. Surprisingly, despite these worries, markets have managed to stabilize quickly. This resilience can be attributed to several factors, including the prompt response of the financial regulators, the limited use of emergency programs, the resulting change in tone towards future monetary policy from the Federal Reserve, and the calm demeanor of experienced investors who have learned to weather market volatility.
Why Have Markets Shrugged off Financial System Stress?
One of the reasons markets were able to bounce back was the quick response from the financial authorities in the United States and Europe, who were able to set up emergency liquidity channels to support banks and facilitate acquisitions of troubled banks. Unlike during the 2008-09 financial crisis, authorities acted swiftly to prevent further damage, which helped regain market confidence. Although their actions were not perfect, and some may blame the regulators for allowing this to occur in the first place, they were effective in preventing the crisis from spreading.
Not Many Banks are using the Fed's Emergency Programs
Another reason why markets stabilized was that only a few troubled banks were using the Federal Reserve's emergency programs to address their liquidity issues. According to RBC Capital Markets, most of the funds accessed through these programs were used to manage liquidity at two failing institutions (SVB and Silvergate Bank) and to help First Republic Bank, which faced liquidity challenges. This suggests that the problems within the U.S. banking system were specific to certain banks rather than widespread across the industry. Markets were quick to recognize that an undiversified client base and liability mismanagement were idiosyncratic in nature, and hence the banking system as a whole was still sound.
The Fed Appears to have Changed Course
The Federal Reserve's openness to adjust their monetary policy in response to the bank failures also contributed to the market's resilience. Continued rate hikes would hurt the assets and treasuries that are being held by the banks. Hence, continuing to aggressively hike rates would not be conducive to financial stability. As a result, the Fed's recent 25 basis point rate hike may be one of the last in this cycle, even with elevated inflation. RBC Capital Markets expected inflation to naturally decrease in the coming months, which would have warranted an end to rate hikes. The recent banking failures may have simply pulled forward this timeline.
Cooler Heads Prevailed
When surprises arise, investors have often exhibited a “sell now & think later” approach. However, this time around, investors appeared to remain patient to see how the story would unfold. To their benefit, the aforementioned developments not only stabilized the markets, but the major indexes closed higher by the end of the month. This resilience may be attributed to the idea that investors have learned not to react hastily. It may also reflect a market that prefers to just get the recession over with, and any event that could bring a definitive slowdown sooner (and the eventual recovery sooner) is welcome.
As always, be vigilent
Despite the market's recovery, there are still risks moving forward. We are entering a period where liquidity and the ability for companies to raise capital may be in question. Credit is also impacted as lending standards become stricter, making it harder for consumers to spend and businesses to expand. Market participants are monitoring the funds accessed through the Fed's emergency programs and tracking bank deposit outflows. Even Jamie Dimon, the highly respected CEO of JP Morgan, feels that the impact of this regional banking failure has not been fully felt. It is important to note that funds have shifted from traditional bank accounts to money market investment accounts, which could put pressure on a smaller bank’s profitability and ability to lend.
In the near term, the market will likely focus on how credit tightening affects economic trends and recession risks, as well as the Q1 earnings season that starts in mid-April. We recommend a balanced approach to investing in U.S. equities, considering the increased economic risks.