Exempting smaller banks from regulations and the Fed’s tightening are among the causes

A US regional bank crisis that morphed into a test of the weaker banks in Europe this week had its origins in US banking deregulation and rising interest rates, says UBS.

UBS head of global equity strategy Keith Parker in Sydney on Friday. Picture: Britta Campion

A US regional bank crisis that morphed into a test of the weaker banks in Europe this week had its origins in US banking deregulation as well as rising interest rates, according to Keith Parker.

The head of US and  global equity strategy at UBS points to the lift in the asset threshold for systemically important financial institutions under the Trump administration (effectively exempting smaller US banks from Dodd-Frank regulations), the tech-centric focus and lack of hedging by Silicon Valley Bank, and the monetary policy tightening that until recently looked set to accelerate.

“On the asset side, the unrealised and unrecognised losses on securities – that as interest rates jumped the value of the bonds declined – the unrealised losses from that mark down were, for some banks, very large, particularly relative to equity capital,” he said.

“Holding a US Treasury bond is money good at par, but the risk is when you have to sell assets to meet a flight of bank deposits, that is when the vulnerabilities are ­exposed.

“For the regional US banks, the magnitude of deposit flight was extremely large, relative to their balance sheets, and so we’ve seen the closure of a few banks on the back of that.”

He noted that about 30 per cent of deposits held by US banks were until recently earning zero interest rates, and as interest rates spiked there was a shift to more competitive products.

Deposits for the US banking sector were already falling, driven by a shift in deposits to other higher-yielding or safer assets, and in the case of some banks the depositors, on the corporate side, were burning through cash and pulling their deposits to fund costs.

The 10-year bond yield had jumped from 3.32 per cent in late January to 4.06 per cent by early March, and the market-implied terminal Fed funds rate shot up to a new cycle high of 5.7 per cent.

Moreover, interest rates have surged since the inflation problem – caused by pandemic effects and unprecedented fiscal and monetary policy stimulus during the pandemic – proved “persistent”.

The US Fed funds rate surged from a record low of 0-25 basis points to 4.5-4.75 per cent over just 11 months. The 10-year Treasury bond yield soared from 50 basis points to 4.3 per cent in the 14 months up to October last year.

In that context, it’s naive to think the crisis is over as the market has started testing the weak links.

Despite strong rebounds in EU and US sharemarkets after the Swiss National Bank stepped in with a 50 billion Swiss francs ($80bn) loan for Credit Suisse, and 11 of the biggest US banks stepped up with a $US30bn ($45bn) deposit injection for First Republic bank, the Australian sharemarket struggled to rebound on Friday.

The S&P/ASX 200 index lost 2.1 per cent for the week – its worst week in six months.

A six-week fall marked its longest losing streak since the depths of the Global Financial Crisis that ended 14 years ago. Australian banks are well regulated and capitalised, but the priority among global investors this week was to raise cash from risky assets where liquidity allowed.

Just as the market quickly turned its eye from crypto-­focused lender Silvergate, to Silicon Valley Bank, to Signature Bank, First Republic and Credit Suisse, the policy response from central banks has been equally rapid. The Fed rapidly came up with its Bank Term Funding program last weekend and the SNB’s loan to Credit Suisse and US major bank deposits for First Republic came just as fast.

The policy response is set to evolve as fast as the market’s banking system “stress test”.

While the European Central Bank delivered its mooted 50-basis-point rate rise on Thursday despite the turmoil, it removed its hawkish rates guidance. Market expectations of Fed interest rate rises have all but disappeared and Reserve Bank rate rise expectations are following suit.

UBS still expects the Fed to deliver two more rate rises of 25 basis points before pivoting to rate cuts soon after an increasingly anticipated US recession hits, but it recently pushed its US recession timing out to the September quarter and its rate cut timing to the December quarter.

The Fed is expected to argue the banking system remains strong and resilient, and logically should then be resilient enough to withstand a rate rise of 25 basis points, while to pause would signal the FOMC worries that might not be the case. The ECB showed big rate rises are certainly possible.

The thought is that the Fed can continue to separate its monetary policy actions from macroprudential efforts, and the respective tools to address each.

As far as what dominoes will fall, Mr Parker says unlisted assets will need to be revalued.

“It is a worry,” he says. “You are seeing a mark-to-market of asset values as rates have shot up and asset values and multiples need to be re-evaluated – you’re seeing that in public markets. There is obviously a similar issue in private markets, both in equity and debt.”

“For US small caps the interest expense from floating rate debt plus refinancing of short-term debt at current rates would have been something in the order of a 20 per cent to earnings, all other things equal, so they’re getting hit on earnings and coverage ratios.

“I think there are risks around the private side of the market (unlisted companies).

“Usually in later-cycle periods, where that marginal capital has gone, is often most at risk.”