SVB collapse to test Feds faith in a strong, low-risk financial system

By Howard Schneider

WASHINGTON (Reuters) – Earlier this month the U.S. Federal Reserve in a report to Congress gave what has become a standard reassurance: Banks were strong and the overall financial system in solid shape.

That confidence is now being tested as the Fed and other regulators navigate Fridays collapse of Silicon Valley Bank — the sort of event that can seem to be without implications for the broader economy until the full scope and potential impact on market psychology become clear.

Regulators on Sunday were working on a response to contain any fallout from the banks collapse, including a sale to another institution able to make depositors whole. The Washington Post and CNBC both reported officials were weighing measures to backstop all deposits at the failed bank, even uninsured ones.

More broadly, the Fed has tools that are always available to shore up the financial system, including direct loans to banks with adequate collateral through its so-called discount window. The Fed made changes at the start of the coronavirus pandemic to encourage such borrowing, some of which, including a lowered interest rate on discount window loans relative to its benchmark policy rate, remain in place. Banks responded in short order, with discount window loan volumes jumping from near zero to about $50 billion in a matter of weeks.

In crises dating back to the 2007-to-2009 housing collapse, the Fed has shown a willingness to react quickly if problems start to spread, and can often ease financial stress just by saying it is ready to act.

But SVB‘s collapse highlighted whether the Fed’s aggressive rate increases, which took rates from near zero percent a year ago to more than 4.5% today, finally caused something important to “break” as holders of low-yielding Treasury bonds face capital losses and banks, particularly smaller ones, faced tougher terms to attract the deposits needed for operations.

“Will uninsured depositors be made whole？ If so, when, and what does the path in markets look like until then？ If not, what are the direct…and contagion effects？” Karim Basta, chief economist for III Capital Management, wrote on Sunday, mapping out the potential trail from SVBs collapse to broader macroeconomic implications.

‘IDIOSYNCRATIC’

Fed officials have been surprised to some degree by how little turmoil their rate increase have triggered, with some policymakers saying the lack of clear stress made them more inclined to keep raising rates as they work to tame inflation.

That may change now, with some analysts suggesting it could tilt the Fed toward a lower endpoint in its rate-hiking cycle. In that sense, the resolution regulators reach for SVB and the verdict of markets and consumers about it may influence Fed officials gearing up for their next policy meeting, on March 21-22.

The initial sense was that SVBs problems were “idiosyncratic,” as Bank of America analysts put it, with others noting that markets still looked at the largest financial institutions as immune from fallout. Those firms in particular are buffered by the higher levels of capital under reforms enacted a decade ago to cushion them against failure.

When it was closed Friday, SVB had a balance sheet of around $200 billion and was the country‘s 16th largest bank. That is far from the league of the large, systemic players, but big enough to rattle the stock prices of other mid-sized institutions and prompt calls for depositors to be protected beyond the Federal Deposit Insurance Corp’s standard $250,000 limit.

Treasury Secretary Janet Yellen on Sunday all but ruled out a broader bailout of the banks owners.

SVBs collapse appears driven by the sort of rate and funding dynamics the Fed watches for in semiannual reports devoted to financial stability and in documents like the Monetary Policy Report to Congress delivered earlier this month.

The Fed said in its report to Congress that funding risk was “low” in the system overall. The aim now is to keep it that way.

“Large banks continue to have ample liquidity to meet severe deposit outflows,” the Fed report said. “Against the backdrop of a weaker economic outlook, higher interest rates, and elevated uncertainty over the second half of the year, financial vulnerabilities remain moderate overall.”

(Reporting by Howard Schneider; Editing by Dan Burns and Leslie Adler)