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When the Federal Reserve Board\u2019s Open Market Committee meets this week to decide whether to raise US interest rates again it will be with one eye on the economy and inflation and the other on the troubled state of the nation\u2019s banking system.<\/p>\n
If the Fed does what the market expects after its two-day meeting that starts on Tuesday, it will raise the targeted range for the Federal funds rate by 25 basis points, lifting it to 5 to 5.25 per cent in its tenth increase in a cycle that started in March last year.<\/p>\n
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Fed chair Jerome Powell has a lot to weigh up this week. <\/span>Credit: <\/span>Bloomberg<\/cite><\/p>\n It would do so knowing that the rapid rise in US rates has been a major contributing factor to the demise of the Silicon Valley Bank, the Signature Bank and the likely seizure by federal regulators and sale of California\u2019s First Republic Bank this week. The failure of First Republic would be the second-largest in US history.<\/p>\n While a Federal Reserve review of the failure of Silicon Valley Bank released last Friday blamed the bank\u2019s management, the Fed\u2019s own failures as its supervisor, and the Trump administration\u2019s relaxation of the prudential and supervisory regime for smaller banks for the collapse, a major contributing factor was the impact of the rate rises on the value of the bank\u2019s holdings of government securities and its loan portfolio.<\/p>\n Had those securities been marked to market, the bank would have faced $US15 billion (nearly $23 billion) of unrealised losses. Confronted with the start of a run on its deposits, Silicon Valley was forced to sell $US20 billion of those holdings to raise cash, realising $US1.8 billion of losses and igniting a massive panic, fuelled and accelerated by social media, that caused its implosion.<\/p>\n The Silicon Valley Bank failure also spread contagion with the regional and local bank sectors that do the bulk of mortgage and commercial property lending in the US, with First Republic the biggest and most impacted of those institutions.<\/p>\n It had $US176 billion of deposits at the start of this year with about $US104 billion of them above the $US250,000 deposit insurance cap, making it acutely vulnerable to a rush for the exits by fearful depositors.<\/p>\n Last week it revealed it had experienced the withdrawal of more than $US100 billion of deposits in March, excluding $US30 billion that 11 major banks had pumped into it in a failed attempt to avert a crisis.<\/p>\n Now it appears that the Federal Deposit Insurance Corporation will seize control of the bank, whose share price has fallen almost 98 per cent from the year-high in February \u2013 the bank\u2019s market capitalisation has plummeted from more than $US27 billion to $US653 million \u2013 and sell its assets off to one of the number of big banks it asked to submit bids at the weekend.<\/p>\n Among them were JPMorgan Chase, PNC Financial, Citizen\u2019s Financial and Bank of America. JPMorgan (which led the group of banks that deposited $US30 billion with First Republic) and Bank of America, which already hold more than 10 per cent of US bank deposits, would need an exemption to acquire First Republic\u2019s assets. There are reports that Bank of America has decided not to bid.<\/p>\n The fate of First Republic Bank remains up in the air.<\/span>Credit: <\/span>Bloomberg<\/cite><\/p>\n First Republic\u2019s woes might have stemmed from the implosion of Silicon Valley Bank but they underscore the vulnerability of large parts of the US banking system. Banks borrow short and lend long and, while they do hold significant levels of liquid assets, there\u2019s never going to be enough of them to stave off a full-scale run on their deposits.<\/p>\n Banks holding large volumes of deposits above the insured level, like First Republic which held a lot of corporate and individuals\u2019 deposits from California\u2019s big tech sector, are particularly vulnerable in the current environment because they are sitting on large unrealised losses from their holdings of government securities and mortgages because of the rapid rise in interest rates.<\/p>\n They are also experiencing increasingly contracting net interest margins as US rates rise. First Republic\u2019s loans and holdings of securities, for instance, generated a yield of about 3.7 per cent in the March quarter. Attracting new deposits or replacing fleeing depositors with wholesale funding would cost closer to 5 per cent.<\/p>\n Further Fed rate rises can only increase the pressure on vulnerable banks, whether they are mismanaged or not. The levels of unrealised losses on holdings of government securities and loan portfolios will increase and interest margins will be squeezed even harder.<\/p>\n Higher interest rates and reduced liquidity are also imposing pressure on the US commercial real estate sector, raising the prospect of a surge on loan losses for the regional and local banks that provide most of that funding.<\/p>\n That\u2019s why the Federal Deposit Insurance Corporation might have to pay one of the big banks to take First Republic off its hands, picking up the tab for the losses on the bank\u2019s securities holdings and loan portfolio.<\/p>\n The likely demise of First Republic would make it the biggest US bank to collapse since Washington Mutual, with assets of $US424 billion, failed during the 2008 financial crisis. Given the speed at which it was enveloped by the contagion that spread from the runs on the Silicon Valley and Signature banks, there is no guarantee that a resolution of its fate will end the mini crisis in the US system.<\/p>\n That complicates the Fed\u2019s efforts to bring down the US inflation rate. It may have to choose between prioritising inflation and the risk of a wider banking crisis.<\/p>\n Further Fed rate rises can only increase the pressure on vulnerable banks, whether they are mismanaged or not. The levels of unrealised losses on holdings of government securities and loan portfolios will increase and interest margins will be squeezed even harder.<\/p>\n The Fed would be very conscious that its rate decisions over the past year \u2013 raising the federal funds rate from near zero to around five per cent and tightening of liquidity and credit conditions by allowing the portfolio of bonds and mortgages it acquired during the worst of the pandemic to run off without reinvesting the proceeds \u2013 have played a significant role in the bank failures.<\/p>\n It would also be acutely aware that if it eases up in the fight against inflation it may become entrenched and require even more painful and destructive measures to get it under control.<\/p>\n The latest data on US inflation has shown that \u201ccore\u201d inflation \u2013 excluding food and fuel \u2013 remains stubbornly high. In March it was 0.3 per cent higher than in February and 4.6 per cent higher than March last year.<\/p>\n That\u2019s why market analysts think the Fed will lift rates another 25 basis points as probably the final but possibly the penultimate increase in this cycle despite the implications for the smaller banks already experiencing stress.<\/p>\n The Market Recap newsletter is a wrap of the day\u2019s trading. <\/i><\/b>Get it each we<\/i><\/b>e<\/i><\/b>kday afternoon<\/i><\/b>.<\/i><\/b><\/p>\n<\/p>\n
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