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.