Market Deep Dive: Potential regional bank failures and uncertainties

Last week, US regulators announced that JPMorgan Chase would acquire all assets and deposits of First Republic Bank, which had experienced a sustained bank run. This has led to speculation about which regional bank might be next, with PacWest Bancorp and Western Alliance making headlines this week.

In contrast to the 2008 financial crisis, which was characterised by high-risk mortgage-backed securities, the current situation is relatively straightforward. The failures of First Republic, Silicon Valley, and Signature Bank (representing three of the largest bank failures in US history) were primarily caused by three factors.

Firstly, regulations for small and mid-sized banks in the US are less strict compared to those for the nation’s largest banks. Secondly, these banks had an incentive to inflate the asset side of their balance sheets with high-duration bonds and mortgages held at amortised cost, making them immune to rate changes in their statements and as a consequence they were able to increase revenues without impacting PnL volatility. Thirdly, their client base was highly concentrated with deposits exceeding the $250k insured by the Federal Deposit Insurance Corporation, leaving them vulnerable to withdrawing their funds during a bank run.

The Fed’s rapid increase in interest rates made the eventual downfall of these institutions inevitable. However, with greater transparency regarding their asset-liability management, the problems would likely have been detected much earlier. Unfortunately, such transparency remains a black box for outsiders and is not mandatory. The impact of these bank failures on the global financial market has been minimal, as regulators intervened quickly, and all client deposits were made whole. This is likely to persist, provided the balance sheets of larger institutions remain robust and assuming there are no other ticking time bombs that are currently being overlooked.

On Wednesday, the US inflation print was in line with expectations but still well above the Fed’s target of 2%. A decrease to target would equal a month-on-month inflation of around 0.15%, while current figures of CPI and core CPI are at 0.4%.

The Fed hiking path going forward remains uncertain, with no hike priced in for the June meeting, and a 50% chance of a first cut in July. A rate cut in July would be very surprising, and only a serious escalation of the US banking crisis or a significant and swift cool down of the US economy would justify such a sudden move in direction. A potential US debt default is worrying the market as well, but the chances of an actual default are small, and it seems to be just political drama.

Keeping rates at current levels makes much more sense as it will likely help move inflation lower. The US economy and markets have been surprisingly resilient against one of the fastest hiking cycles in US history. However, a decrease in rates would cost the Fed credibility in their fight against inflation. The Fed has already proven to the market that they will not automatically respond to nervousness in the market as in the past. Therefore, market participants should be cautious about counting on the Fed.


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