A question of trust

If SVB has invested some of these deposits in loss-making assets (treasuries in SVBs case) then shareholders and bond holders could clearly still suffer in the case of difficulty for the bank even if the bank’s deposits are fully guaranteed.

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Many man hours and column inches have been devoted to the ballooning of central bank balance sheets that have resulted from asset purchases under QE. Unsurprisingly, there has been a good deal of disquiet about the risk that these pose.

To put the rise in context, in the US the Fed’s assets have surged from under USD1tr at the time of the global financial crisis to around USD8.4tr today, and from a peak of around USD9tr last year. Prior to the crisis Fed assets had tracked cash in circulation very closely; which is what we would expect when commercial banks keep minimal reserves with the Fed. If Fed assets had continued to track cash in circulation, they would be standing at around 2.25tr today, not USD8.4tr.

Such hefty asset holdings create question marks about the Fed’s dominance in the bond market; something that has been far more problematic in Japan given that the BoJ now owns over half of the JGB market.

But the focus today is more on the counterpart of this surge in Fed assets, which is the surge in deposits of the banking system, and particularly uninsured deposits which make up most of the deposit base.

In theory, at least, banks welcome high deposit levels but there’s a question here of whether the rapid build-up leaves banks particularly vulnerable to rapid withdrawal as rates on other assets rise, and as we’ve seen, as the power of social media works to fast-forward bank runs. In the end, of course, banking comes down to trust. Do customers trust the banks in which they have placed their deposits? Insuring deposits can reduce banks’ dependency on such trust, but can insurance remove these trust issues completely? In the US we currently have this rather odd situation where the Fed guaranteed all deposits at recently impacted banks, but only implied that this applies to other banks as well. Even if we can take deposit guarantees as a cast-iron commitment from the authorities, does this eliminate the trust element completely? It might amongst depositors, but what about stock and bond holders in the banks?

If, like Silicon Valley Bank (SVB), the bank has invested some of these deposits in loss-making assets (treasuries in SVBs case) then shareholders and bond holders could clearly still suffer in the case of difficulty for the bank even if the bank’s deposits are fully guaranteed. Clearly lots of banks have loss-making assets on their books and many in assets they can’t be quickly redeemed like treasuries. The Federal Deposit Insurance Corporation (FDIC) put these at just over USD600bn at the end of March or just under 30% of their capital – and there are many estimates that put the figure much higher.

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Of course, banks can try to hold to maturity their loss-making assets but funding these assets could still prove problematic even if deposits are guaranteed. In other words, it seems that the issue of trust is still important and, in the current febrile environment it seems hard to suggest that such trust won’t be challenged.

Many have argued that the non-bank financial sector actually holds the biggest risks and here we might argue that trust is even more important given the lack of emergency support from the regulators that the banks enjoy. Should the non-bank sector wobble in certain areas the spillover to banks could still be severe irrespective of any implicit, or explicit, deposit guarantees.

As for the idea that these risks will recede once the Fed reaches peak rates, Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks it lacks validity, just as it does even when the Fed starts to cut rates. The bottom line is that concerns about banking stress seem unlikely to go away quickly and that will probably weigh on the ability of riskier assets to maintain some of the strength that we’ve seen recently. It also helps explain why we’re not sold on the idea of a significant weakening of the dollar just yet.