Regional Banking Crisis?
February 1, 2024
Here we witness a familiar scenario unfolding once again. The Federal Reserve's assertive decision to increase the Fed Funds Rate, aimed at taming inflation, has inadvertently applied pressure on the banking sector. This pressure has materialized in the devaluation of balance sheets, leading to some notable failures. The crux of the issue lies in the Mark-to-Market accounting of the assets held by these banks. The valuation of these assets is highly sensitive to fluctuations in interest rates, necessitating daily reassessment based on market events, particularly those related to interest rates.
This situation, however, diverges from the 2008 financial crisis, which was rooted in the quality of assets. The present challenge stems from the Fed's aggressive rate hikes, resulting in asset devaluation that has triggered a "Run on the Bank," as depositors lose confidence in weakened balance sheets. Unlike 2008, where bank assets were subpar, to say the least, today's banks hold quality and performing assets. However, as a consequence of the rate hike, these assets are currently being assessed at 20% to 30% below their face value. Nevertheless, with the recent halt in the Fed's rate hike, the escalation of asset devaluations should be mitigated.
In my perspective, I don't consider the current situation to be a crisis. While there might be occasional failures, particularly in the case of further deterioration in commercial real estate, I have confidence that the overall sector will navigate through its challenges. However, I do anticipate some consolidations within the regional banking sector, considering the considerable number of 4,135 community and regional banks in the US. It raises a pertinent question: is the abundance of banks in the US justified?
My primary concern centers on the potential unfolding of a yield curve normalization if long-term interest rates increase, rather than short-term rates declining. This could trigger further asset devaluations, intensifying the risk of a mass exodus of deposits toward a select few large banks, potentially initiating a "Run on the banks." Such a scenario would introduce considerable pressure to regional banks, amplifying challenges and uncertainties within the sector.
While this assessment deviates from my earlier comments, the highlighted concerns may serve as a catalyst prompting the Federal Reserve to consider accommodating the plea from Capital Markets. A potential response could involve lowering the Fed Funds rate to a range between 3% and 4%. This adjustment is perceived as an ideal scenario, aligning with the interests of both the market and the banking sector. Now, the big question is: will the Federal Reserve deviate from its primary goals of maintaining price stability and achieving full employment to consider what might be most beneficial for the market or a specific sector?
In the event of a deteriorating credit environment leading to an increasingly challenging situation, I recommend implementing two regulatory measures to address the circumstances. Firstly, consider a temporary suspension of "Mark-to-market" accounting, even though its feasibility is questionable. The second proposal involves implementing asset swaps instead of injecting capital or extending deposit guarantees. In this scenario, the US Treasury Department, exempt from Mark-to-Market requirements, could issue new Treasuries and exchange them for devalued assets on banks' balance sheets, thereby promptly reinforcing banks' financial standing. The Treasury has the option to retain the devalued assets held by banks until maturity, enabling them to receive the face value of these assets. In the event of a default, the Treasury can accurately quantify the losses and, if necessary, recoup these losses through additional interest charges imposed on the banks. This approach stands in contrast to injecting capital, where the actual extent of losses remains uncertain, contributing to an augmented national debt burden on taxpayers.
Another viable option would be to refrain from interference altogether. True capitalism prevails when unviable companies fail and viable companies flourish. When companies face failure, they can either be liquidated or attract investors to revitalize them. The regulators' role is to establish and enforce rules, fostering an environment where true capitalism thrives. This perspective aligns with the notion that regulators should set the rules and ensure adherence, embodying the essence of true capitalism.
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