Bottomline | Beware the US banking fallout

Government and central banks are torn between the moral hazard of bailing out errant entities and the need to maintain financial stability in the market. While questions have been raised over whether Silicon Valley Bank was too big to allow it to fail or not, what’s emerging clearly is that the problem is far deeper and wider than earlier perceived.

Besides, given past experiences, like in the financial crisis of 2008, it isn’t as if the authorities came up short. Reports suggest that bailing out Freddie Mac, Fannie Mae and AIG eventually returned much more to the government in dividends and other forms than the amounts committed for the bailout. This, perhaps, also works in favour of action to support distressed entities. Even private players stepping in or being asked to step in, as is being seen in the UBS’ likely acquisition of Credit Suisse or 11 banks depositing $30 billion with First Republic Bank is not a new phenomenon. JP Morgan bought Bear Stearns with a $30 billion cover for risky mortgage assets of the lender from the Federal Reserve. That did not turn out well for JP Morgan, Jamie Dimon has publicly acknowledged, but not all cases are the same. Investors asked to step in to save Yes Bank, led by SBI, are likely to see positive returns on their investments.

So, the US government and the Federal Reserve may be willing to take more steps to instil confidence in the financial system, and some relief on backstopping deposits of other small banks—following a demand reportedly made by them for a 2-year assurance—may not come as a big surprise. But that is also a reason for worry.

A report in the Wall Street Journal suggests economists estimate that 186 banks could be at similar risk as Silicon Valley Bank, with about 10 percent having higher unrecognised losses and 10 percent having lower capitalisation than Silicon Valley Bank. And those with significant decline in asset values have increased the fragility of the US banking system and are at risk of depositor runs.

A Goldman Sachs report highlights the significance of the small banks problem. It says: “Small- and medium-size banks play an important role in the American economy. Lenders with less than $250 billion in assets account for roughly 50 percent of US commercial and industrial lending, 60 percent of residential real estate lending, 80 percent of commercial real estate lending and 45 percent of consumer lending.” It goes on to suggest this will lead to lending standards tightening to a degree that’s greater than during the dot-com crisis, but less than during the financial crisis or the height of the pandemic.

This is bound to crimp credit and further add to the deceleration of the US economy, increasing risk for markets.

An interesting aspect possibly not fully appreciated by many in Goldman Sachs’ expectation of the US Federal Reserve pausing on rate hikes, is their rationale behind this. The report suggests that the “the incremental tightening in lending standards from small bank stress would have the same impact on growth as roughly 25-50 basis points of rate hikes would have via their impact on market-based financial conditions.” Thus, Goldman Sachs doesn’t see “effective” rate hikes at much lesser than earlier, but part of the impact being delivered by a tightening of credit by lenders to cope with the new banking sector fragility.

This isn’t good news for equities. High rates, tighter credit, weakness in the housing market, affordability eroded by inflation are all factors pointing to more pain ahead. So, stay watchful, stay wary.

Invest only selectively in deep value that emerges from a bottom-up perspective with a long-term holding bias.