Addendum to "SVB was not a typical bank run"

Turns out that I could have saved my words on Wednesday, and rather than write a blog post, I could have shared a link to interview with Douglas Diamond of the Diamond-Dybvig fame:

https://finance.yahoo.com/news/economist-won-nobel-bank-runs-160025143.html

Huge credit to him for avoid the natural inclination to say "it is all in my models". This was far from DD bank run!

 

SVB was not a typical bank run

 

We know that SVB faced a run on the bank. But there are bank runs and there are bank runs. Was it typical bank run ala Diamond and Dybvig (DD), with illiquidity and sunspot equilibria? Or was it different?

While there were some aspects of the typical bank run – reliance on demand deposits, sudden shift in depositor sentiment – there are important aspects in which it was not a typical bank run. To see that, notice that typical bank run of DD style features one key aspect: inability to liquidate assets without a penalty, and hence mismatch between liquidity of assets and liabilities.

(Sure, it might seem that liquidating assets by the SVB would be costly to the bank. But the reality is that it would not carry a penalty cost, but rather that it would be associated with realizing the losses which have already occurred in the real world.)

The key point is this: In contrast to DD scenario, the asset side of the SVB was extremely liquid, mostly in form of government bonds and government-backed securities. While selling those in bulk would carry some penalty, this would be small – and if the market reaction after the collapse is anything to go buy, plausibly the prices would have even moved in the favorable direction. So the SVB case did not feature the key aspect of DD bank run, the liquidity mis-match.

It was also not similar to the bank failures in 2008. Back then, the problem was still liquidity mismatch: while the assets were securities and not loans, and hence were partially liquid, they were risky assets and selling them in bulk was not an option: due to classical finance problems (information asymmetries, limited arbitrage capacity) the large-scale selling would lead to large penalty. This is also why a regulatory  environment requiring large amount of liquid assets would be irrelevant: SVB did hold large amount of liquid assets.

Therefore, the problem of SVB was more about insolvency rather than illiquidity. True, the insolvency was of unusual type – it was not credit or loan losses, but losses related to interest rate risk, something we typically do not think as major source of solvency risk; and if the bank would not be run on, it would probably turn around and become solvent. But irrespective, it was the current value of its assets, not its inability to quickly liquidate them, which was the problem. And at the same time the current market value of the assets was in now way related to liquidity problems, but simply reflecting different risk-free rates.

So no, this was not a bank run from the 1983 paper, and neither it was a bank run from the more modern fire sale literature.

Update on scenarios after SVB failure

Ok, we now know what the player next in turn did: The regulators and government officials decided to take out the bazooka right away without hesitation. As I said yesterday, "this time around this would come much sooner than it did in 2007-2008 – the action during pandemic showed that with large financial crisis in recent memory, the point when political establishment acts is significantly earlier than otherwise.". This is especially so given that Yellen is sitting at the Treasury.

This changes the likehood of the scenarios quite a bit:

Nothing happens: 20-25% >>> 30-35%

Tremors without casualties: 25-30% >>> 30-35%

Some casualties, but situation remains contained: 25-30% >>> 10-15%

Contagion which is eventually contained: 10-15% >>> 5-10%

Nothing happens: 2-5% >>> 2-5%

Effectively, with forceful action from the government providing backstop to the uninsured depositors the middle of the probability distribution has hollowed out: It is much more likely that this will end as soon as it started. However, this does not mean that adverse outcomes are ruled out. It is just that now they would require other mechanisms to occur, which is less likely. This even applies to the middle outcomes: I dont think we have a good model of depositor's beliefs formation, and it is still likely that at least some of them will act out of caution despite the government guarantee. It is just that now it is rather unlikely this will reach a critical mass. 

Rather than the depositors, the behavior to watch now is of bond holders, sources wholesale funding and stockholders. Bond and stock holders were wiped out in SVB, something that officials did only in rare occasions in 2008 out of fear. It remains plausible that they will pull out in more meaningful fashion. And there is still possibility that there are vulnerabilities we do not know about. Therefore, the probability of truly adverse outcomes has not decreased much.

Addendum: Looking at my probabilities, I realized that the wording of "without casualties" is not aligned with the exact idea in my head. I really mean no meaningful casualties. E.g. few small banks failing still qualifies as "no casualties". By no casualties I mean no banks in the size range of SVB or larger fail.

Scenarios after SVB failure

 

The first thing to realize that at this moment failure of SVB is a failure of single financial institution. And while SVB was not a small bank - with north of 200 billion in assets it ranked as 16^th largest in the US – neither it is a large-enough bank for it to be systematically important. To realize this, notice that it felt under both the more strict (250 billion) and even the more relaxed (500 billion) threshold for participation in annual Federal reserve stress test exercise. Therefore, in isolation, its failure does not pose a threat to the financial system. The question, though, is what does this imply for the rest of the financial system.

Of course, this is impossible to know with certainty. In such situation, it is useful to spell out possible scenarios, and try to assign (necessarily subjective) possibilities to each scenario.

Nothing happens

Option 1 is that this will be fully self-contained to SVB, and then after few days financial markets realizing the limited nature of the situation will move on. There are many reasons for this case. First, SVB was clearly unique among large(r) banks in terms of its vulnerability. On asset side, it had unhedged interest rate exposure, while other large banks have their interest rate exposure hedged away, something that is a public knowledge. On liability side, SVB was funded by uninsured short to much bigger degree than other banks, partly due to its rapid growth, as its assets quadrupled since start of the pandemic. Moreover, the depositors were from relatively tightknit community, which meant that the news about weak position of the bank spread very quickly among its depositors, with some of the voices of the community, such as Peter Thiel acting as amplifiers. We know that such conditions make run by depositors much more likely.

In other words, SVB was uniquely vulnerable among large(r) banks, both on asset and liability side. And this uniqueness might mean that its failure will be a one-off and no other banks – or at least no other banks with any meaningful size – face pressures and fail. There are ample precedence for isolated failure of non-systemic bank in situation when other banks do not share its vulnerabilities on asset and liability side.

Likelihood: 20-25%

Tremors without casualties

While SVB was unique among large(r) banks, it does not mean that many of the small and medium banks do not face similar problems. Over last couple months there were news of this bank segment in the US facing funding pressures related to rising interest rates and associated outflow of funds, as depositors opted for higher yielding government money markets.

Moreover, whether SVB was unique or not really is subjective. It is entirely plausible that depositors will consider SVB more similar to other banks, especially Californian banks. Indeed, there are signs of troubles at few other medium-sized banks with similar profile as SVB. This could mean that small or large share of depositors decide to pull their money from these banks.

What happens after that really depends on the scale of fund outflow. If it is relatively small, possibly limited by appropriate noises from government and regulatory officials, then this pressure could eventually die without claiming any other casualties. This is especially likely if the resolution of SVB is favorable to its depositors.

Likelihood: 25-30%

Some casualties, but situation remains contained

On the other hand, if the resolution of SVB is unfavorable to uninsured depositors – or only eventually favorable, with doubts about their fate in coming days/weeks – then the likelihood that the pressure on other small and medium banks yields further casualties is large. However, this does not mean that things will get out of hand. It is very plausible that after few bank failures the  situations calms down, as financial markets and depositors realize that the problems are limited to few institutions rather than widespread. Or alternatively, after some period regulators and government officials come up with a forceful action. In essence, this scenario amounts to weeding out the weakest banks without ramifications for the rest of the financial system, something that we have also seen before. This is in line with academic literature that suggests that it is the weaker banks that typically fail.

This and previous are the most likely scenarios: for things to get out of hand and us to end up with more or less limited financial crisis, it is not enough for one bank to fail (as long as it is not central to the financial system). You need the wider financial system to face the same vulnerability, either on asset or on liability side, or both. While there are some shared vulnerabilities on asset side, as far as we know, these rather limited. And on liability side the wider banking system is in very different situation, with large amounts of excess reserves. And on top of everything, the large systematic banks are very well capitalized, as far as we know.

Likelihood: 25-30%

Contagion which is eventually contained

While direct implications from SVB failure is limited, and its vulnerabilities are not shared by the wider financial system, one cannot rule out that the wider financial system will be affected. The most likely reason for this to happen is for the resolution of SVB to be unfavorable both to bond holders and uninsured depositors., This could plausibly be because of limitations on interventions from regulators and the Fed imposed by the new regulatory rules after the global financial crisis. This could sawn doubt into bond holders and depositors about the backstop offered to other institutions in case they get into trouble. As a result, they could pull to safety of either other instruments or larger, safer institutions. And like that the crisis would start to spread to wider financial system.

In such an event it is likely that an action to stop the contagion would eventually come. The typical script of financial crisis is gradual encroachment of the crisis onto wider and wider circle institutions until the pain becomes too large for the political system and there is resolute action. Plausibly, this time around this would come much sooner than it did in 2007-2008 – the action during pandemic showed that with large financial crisis in recent memory, the point when political establishment acts is significantly earlier than otherwise.

Likelihood: 10-15%

Gradual escalation to full blown financial crisis

Despite all this, things could get evolve into full blown financial crisis. Financial systems always seem resilient until they are not. It is possible that the problems of SVB are more widely shared, or that the repercussions of its failure will reveal vulnerability we do not know of. If the global financial crisis taught us something it is that there are parts of financial system which are little known until they blow up. In the same way, we might be sitting in front of ticking bomb and not know about. While plausible, this remains rather unlikely.  

Moreover, we are clearly in early stages of developments, so even if we were to go there, it would take at least couple months of gradually worsening situation. The analogy of SVB to the 2007-2008 period is the early failures of summer 2007, and especially the Northern Rock episode. Northern Rock was actually very similar in many ways: the rapid growth prior to failure, the reliance on short-maturity liabilities, and only limited problems on asset side. Both SVB and Northern Rock were vulnerable because of their funding structure rather than because of the asset side of their balance sheet. If this analogy is suggesting something, then it is that even if this will become something serious, we would need to go through the gradual escalation, that would take months, if not longer.

 Likelihood: 2-5%

Macroeconomic implications

If SVB will prove to be a standalone, then the story will be soon confined to historical textbooks and will not have any ramifications on wider macroeconomy, beyond likely making Federal reserve more cautions and opting for 25bps hike on Wednesday, rather than 50bps hike which was the baseline as of Thursday morning.

If it leads to pressure on other banks but no other failures, then the implications would be very similar, albeit it might lead to tightening of financial conditions and weakening of the economy sometime down the road. The implications for immediate monetary policy would be again limited, albeit the hiking might stop one or two meetings sooner then otherwise.

This is more likely under the scenario where there will be other failures, but things will not get out of hand. Depending on the speed of developments, this could mean that March hike is the last one by the Fed, while ECB will very likely make at least one more hike in this scenario.

What if this continues to gradually escalate? Assuming that things don’t worsen rapidly it would likely mean recession later this year and corresponding rate cuts. This means that only rapid escalation, which remains rather unlikely, could mean that the ECB would stop hiking already in May. Rather, this puts into question the hike in June and July, and has implications for size of hike in May.

 

 

 

 

 

 

Is it or isn’t it a recession?

On regular basis we are now having discussion in Europe whether “something” is or is not recession. Inevitably, these discussions lead to conclusion that while we started talking about the aspects of that “something”, the discussion is really about “what is recession” rather that whether this particular something is a recession. In other words, the discussion we need to have is what constitutes a recession, rather then discussing the details of the economic situation.

Czechia example

Consider the example of Czechia. Here are the facts:

• GDP has contracted for two quarters in a row, each time around 0.3% non-annualized. It is still below its pre-pandemic peak.
• Consumption has contracted for 5 quarters in a row, cumulatively 7.6%.
• Fixed investment has decreased in last quarter as well, albeit after strong recovery throughout the previous year and a half.
• The reason why GDP did not drop more is because net exports surged from their extremely low values reached during the pandemic period. In last quarter government consumption also helped a lot.
• Despite all the weakness, labor market is tight, with unemployment rate close to its pre-pandemic historical lows (in case you don’t know, it is ridiculously-sounding low at 2.1%).

Is this a recession? In many dimensions it is. I mean, 7% drop in consumption is simply gigantic; for comparison, during great recession, there was almost no contraction. Now it is accompanied also by drop in investment. And then there are the two successive declines in GDP, which would qualify as recession according to the silly definition for “technical recession”. On the other hand, the 0.6% drop in GDP is far-cry of normal recession. And above all, it just does not feel like recession here on the ground. It just feels like pretty depressing period for consumers.

Are there recessions in RBC models?

Yesterday, my boss had an interesting idea. Maybe we should look at things like defaults and bankruptcies, rather just macro aggregates, when determining whether something is or is not recession. I then built upon that idea further and to put focus on self-reinforcing demand shocks as the key aspect of recessions.

To see this start with following question: Are there recession in RBC models? The question of recessions was one of the first controversies between proponents and opponents of RBC models. The reason was that RBC models explained fluctuations in output as fluctuations in the productive capacity of the economy, rather than output falling below such productive capacity. This led to the classical critique question of “What are the productivity shocks”, as declines in productive capacity required negative productivity shocks. Such shocks were at odds with the understanding of productivity at the time, given that productivity was understood as akin to technology or knowledge. (By the time I was reading this discussions I was not that puzzled: if you think about productivity more broadly it feels very natural that it could easily decrease following a shock; an example below).

Therefore, RBC models did and did not feature recessions. They did in the sense of output declining in some periods of time. But they did not, in the sense of output being below its (short-run) potential. I.e. there were no output gaps. Only the move from RBCs to new Keynesian models allowed for this possibility more broadly - albeit for a long time only to a limited extend – by introducing nominal rigidities which could give rise to demand driving the decline in output. And I think this contrast in perspectives is actually very useful for current situation.

Real shocks and demand shocks

To see how the perspective of real shocks vs demand shocks is useful now, consider back the case of Czechia. How can we explain the current economic developments? I think it I fair to say that the economy is undergoing large real shocks, both positive and negative. On the negative side, the surge in energy costs is a very large and - crucially – real shock, in that it changes the productive capacity of the economy. Moreover, at this point in time it also leads to redistribution of output away from consumption, which to some degree might be optimal. Meanwhile, the reason why output did not collapse more is because at the same time the economy also faced large positive real shock in form of global supply bottlenecks unwinding, which in turns I just reversal of previous large negative real shock. (All of these are examples of negative productivity shocks, since productivity and technology are separate).

What is crucial, though, is the fact that these real shocks have so far not been accompanied by negative demand shocks. In the words, the typical mechanism though which recessions are self-reinforcing – drop in demand causing further drop in demand through various channels – has not kicked in. This can be seen in things like firms not firing people or aggressively cutting down their orders and slashing inventories in response to uncertain demand environment. It can be seen in that the financial channels being so far very silent: there hasn’t been a wave of defaults leading banks to curtail the supply of credit. Simply, while both consumers and firms are being hit by shocks, they have not started worrying about the outlook in a way that would cause them to change their behavior above and beyond what the shocks require.

No recession – but what is it then?

And this is why I don’t think Czechia is in recession. Neither is any other European country so far. Simply, a recession really requires a demand shocks to occur, and they have not occurred yet. I mean this in the sense that demand is so far only responding to the real shocks hitting the economy, and is not additional source of shocks, at least not to a significant degree.

Of course, what is not yet the case might soon come to be: there is nothing that says that firms will not lose their faith as their order books are depleted and start slashing their demand and laying of people. And if that starts happening, then it could gain speed pretty quickly. But in absence of this happening, the economy will proceed along its current trajectory, struggling to generate much growth before the effects of real shocks start to reverse. Will the resulting path be a recession? I don’t think so. At the same time I am sure it will not be fun either. Seems like we need a better terminology.

P.S.:  Was pandemic recession a recession in this view? I would say yes, because there was a demand component. Financial channels were very alive and kicking. Firms like car producers slashed they demand for inputs expecting slow demand from their customers. Sure, the demand was not the dominant factor, which is why the recovery from the recession was very different from great recession. Of course, the main reason why demand played limited role is because of the demand management: fiscal and monetary policy prevented collapse in demand and actually gave additional boost to demand. But that is another story.