About the authors: Viral V. Acharya is CV Starr Professor of Economics in the Department of Finance at New York University Stern School of Business and former Deputy Governor of the Reserve Bank of India.
Raghuram Rajan is Katherine Dusak Miller, Distinguished Professor of Finance at the University of Chicago Booth School of Business. He was Governor of the Reserve Bank of India and Chief Economist and Research Director at the International Monetary Fund.
In his recent testimony to Congress, Federal Reserve Chairman Jerome Powell said, “The ultimate level of interest rates will likely be higher than expected” and “Restoring price stability will likely require that we maintain tight monetary policy for some time.” How the financial world has changed since then.
Silicon Valley Bank and Signature Bank, with about $200 billion and $100 billion in assets, respectively, collapsed. More than 90% of deposits at Silicon Valley Bank and Signature Bank were uninsured. Uninsured deposits are naturally prone to runs. In addition, both banks had invested large sums in long-term bonds. Thus, with the rapid rise in interest rates, the value of their bond portfolios fell. When
sold some of these bonds to raise cash, the losses embedded in its bond portfolio began to show, triggering the depositor rush that led to its closure.
The worry is that other banks could have the toxic mix of long-term, interest-rate-sensitive assets funded by short-term deposits. If depositors remain panicked, more small and medium banks could fail. After all, what corporate treasurers would want to confess to their CEOs that they didn’t transfer corporate deposits to a large, rock-solid bank, knowing the stress Silicon Valley Bank customers face? No wonder the government backed all the filings.
There are a lot of complaints to be made. But beyond banks’ risk management and the apparent failures of banking supervisors, there are deeper issues. Why have uninsured deposits increased so rapidly during the pandemic? Why do banks invest so much in long-term securities portfolios? Why are we seeing bank runs so soon after the Fed floods the system with cash?
Part of the answer lies in quantitative easing, a form of monetary easing adopted after the global financial crisis, in which the Fed buys securities in the market in exchange for its own cash reserves (a form of cash). In co-authored work that that we presented at the Federal Reserve’s Jackson Hole conference in August 2022, we show that quantitative easing is difficult to unwind as the financial sector becomes dependent on easy liquidity. Commercial banks, which typically hold the reserves provided by the Fed during quantitative easing, fund them with short-term, uninsured, demandable deposits. Indeed, as the Fed resumed quantitative easing during the pandemic, uninsured bank deposits grew from around $5.5 trillion at the end of 2019 to over $8 trillion in the first quarter of 2022.
Moreover, although Fed reserves are the safest assets on the planet, they yield little. Thus, to fund their reserve holdings, banks are even substituting their more stable but expensive term deposits with cheap demand deposits. That quantitative easing is associated not only with an increase in the size of the central bank’s balance sheet, but also with an expansion of the banking system’s balance sheet and its uninsured demand deposits, is little appreciated.
Moreover, we find in our study that even if the Fed withdraws reserves from the system through quantitative tightening, the banking sector does not quickly reduce the uninsured deposits it has issued. Thus, the system becomes a crash waiting to happen, since uninsured demand deposits can run out at the first sign of trouble.
Vulnerability has been increased by greed. Banks like SVB were not content to hold low-yielding reserves. Their search for yield has led them to hold securities for the long term. They made small spreads as long as interest rates remained low, with the risk of large losses if the Fed raised rates abruptly; a classic case of picking up pennies in front of a steamroller.
We saw a milder glimpse the last time the Fed engaged in quantitative tightening, beginning in late 2017. Even relatively small unexpected increases in demand for cash, such as an increase in the Treasury account at the Fed, caused a massive dislocation of the Treasury. repo markets in September 2019. The Fed stopped quantitative tightening and resumed injecting reserves, but that was not enough to prevent the system from seizing up again with the onset of the pandemic in March 2020. The answer? More quantitative easing from the Fed, more bank issuance of uninsured deposits, and more systemic vulnerability as the Fed reversed course. But this time there was an additional problem. The Fed had to raise interest rates quickly, causing potential solvency problems even as banks like SVB overissued liquidity claims.
In sum, quantitative easing and the long period of low interest rates have heightened the vulnerabilities in the financial system that are emerging as the Fed tightens. The greater the magnitude of quantitative easing and the longer its duration, the more the banking system and financial markets become accustomed to liquidity. Ideally, this means the Fed should take longer to normalize its balance sheet (and ideally interest rates as well). Unfortunately, financial stability concerns conflict with the Fed’s inflation-fighting mandate. Indeed, some market participants now expect rate cuts in times of inflation well above target, as well as the end of quantitative tightening. If problems in the financial sector do not slow the economy, such actions could make the fight against inflation longer and more costly. As it reviews regulation in any postmortem, perhaps the Fed also needs to review its own policies, especially quantitative easing.
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