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It turns out the Federal Reserve has been moving fast and breaking things, but few people noticed until the collapse of Silicon Valley Bank.
Over the past year, the Fed has been hiking interest rates at an aggressive, quick clip in an effort to tame high inflation in the United States. The common adage on Wall Street is that the Fed increases rates until something breaks. Until last week, the question was what, if anything, was breaking. Interest rate increases generally take some time to work their way through the economy, but some people were sort of scratching their heads at just how long that lag seemed to be. The job market, which interest rate increases are aimed at cooling, has remained strong. The economy is generally in surprisingly decent shape. Sure, things looked a little ugly in crypto and tech, but maybe the trouble would be contained there.
Now, the landscape looks starkly different, and we know what the Fed broke: Silicon Valley Bank, or SVB. (Disclosure: Vox Media, which owns Vox, banked with SVB before its closure.)
It will be a long time before we completely understand exactly what happened in SVB’s swift, stunning decline, but there’s little doubt interest rate hikes were a contributor. They were also likely in play in the demise of Silvergate and Signature Bank, both of which have been shuttered in March.
“It’s always a surprise. We didn’t know what would break, apparently it was this,” said Alexander Yokum, an analyst at CFRA Research who covers banking. “This would not have happened if the rates hadn’t gone up so quickly and these portfolios hadn’t gone underwater so much.”
If rates continue to go up quickly, it could pose more problems for more banks. That’s got the Fed in a bit of a pinch — it wants to tame inflation, which remains high, and it also wants to ensure financial stability. Both fronts are looking quite tricky.
“We don’t know what risks are lurking around the corner and what institutions are less sound than we might have thought, particularly if rates continue to go up,” said Morgan Ricks, a professor of banking and finance at Vanderbilt University. “We saw an inflation print [for February] that was a bit higher than expected, and the Fed may end up being between a rock and a hard place here.”
The scenario is also a stark reminder of what’s on the line in the Fed’s efforts to combat high prices and the potential interest rate increases have to wreak on the economy.
“The Fed has wanted to do stuff until something broke, and that something broke. And the next thing that breaks is that 2 million people are going to lose their jobs when the unemployment rate goes up,” said Mike Konczal, director of macroeconomic analysis at the Roosevelt Institute.
Interest rate increases can be a solid deal for banks because they let them charge more on loans and make more money, but as evidenced by SVB, there are risks to them, too.
SVB’s downfall was the result of a bank run after signs of trouble at the bank began to emerge in the second week of March. The bank — which in SVB’s case caters largely to tech, startups, and venture capital — takes deposits from clients and invests them in generally safe securities, like bonds. As the Fed has increased interest rates, those bonds have become worth less. That wouldn’t normally be an issue — SVB would just wait for those bonds to mature. But because there’s been a slowdown in venture capital and tech more broadly, in part because there’s less free and cheap money floating around, deposit inflows slowed, and clients started withdrawing their money. It became clear SVB was in the midst of a cash crunch, which caused panic and ultimately took the bank under.
The concern is that interest rate increases may pose threats to other banks, too. The more rates go up, the more banks could start to be a problem.
“The Fed’s rapid interest rate hiking cycle is having more of an effect on the US economy than many people at all levels, I think, realized even a few weeks ago,” said Josh Lipsky, senior director of the GeoEconomics Center at the Atlantic Council. “I think we can confidently say this is interest rates showing their teeth in the economy.”
To be sure, SVB had other particularities to it. It catered to a monolithic clientele, meaning it was highly exposed to one industry and if that industry faltered, so would it. It also held a high amount of uninsured deposits. Silvergate and Signature, which have also collapsed, had dipped into crypto, which has also been struggling.
Megan Greene, Kroll’s global chief economist, said the unique nature of these banks is worth considering, especially in light of the suggestion that this is all the result of the Fed tightening monetary conditions too much. “I would have more sympathy with that argument if Silicon Valley Bank and Silvergate weren’t so idiosyncratic,” she said. As central banks change conditions, “we are going to hit more pockets of dislocation.” SVB made some real miscalculations on the potential impact of inflation rate increases as well. “Uniquely, SVB didn’t hedge for interest rate risk at all, which is just mind blowing,” Greene said.
Still, SVB is not a complete outlier, and interest rate hikes pose threats to other banks, too, especially if the Fed keeps at them so aggressively. “When rates go up, that pushes bond prices down, and any institutions that are on the wrong side of that can find themselves in a less sound financial condition than we might want,” Ricks said.
That rate hikes might be a problem for banks now becomes a problem for the Fed, because it doesn’t want to break the banking sector. Before SVB’s meltdown, many investors expected the central bank to keep pace with rate increases when policymakers next meet on March 21 and 22. As the Wall Street Journal notes, last week, people were chatting about whether the Fed would raise rates by a quarter of a percentage point, like they did in February, or a half of a percentage point, like in December. Now, that’s changed — many investors, analysts, and experts think that they will slow down or even put a pause on it altogether.
“They should, absolutely, in part because they have done so much tightening already,” Konczal said. He added that economic activity could cool down a little on its own anyway “because everyone’s just a little spooked and freaked out” over SVB.
“Now, they’re in a position where if they hike [half a percentage point] at the next meeting, that’s gasoline on the fire,” John Fagan, former director of the markets group at the Treasury Department, told Politico.
It’s a tough situation. Inflation does appear to be falling, but it remains high. The Consumer Price Index was up by 6 percent over the past year in February.
Gustavo Schwenkler, an associate professor of finance at Santa Clara University Leavey School of Business, said he doesn’t believe the Fed’s overall aims to get inflation down and cool off the economy have changed in light of SVB’s collapse. “The goals that they have right now are much bigger than making sure that the tech sector is fine, but I definitely think that they are very concerned about how investors are going to react to whatever steps they take,” he said. “We might be hearing different ways of communicating from the Fed about what its next actions are going to be…to calm down any uncertainty around this.”
On Sunday, after the FDIC, the Treasury Department, and the Fed announced they would make sure all of SVB’s and Signature Banks’ depositors’ funds would be guaranteed. The Fed also said it was also going to open up a facility to make funding available for other financial institutions in the form of one-year loans. The goal is to try to limit contagion across the banking sector and to stave off other bank runs, like what happened with SVB. It’s an attempt by the Fed to boost confidence so people don’t panic. Greene emphasized that the Fed can both raise interest rates and open up a new facility at the same time. “I don’t think this will change the Fed’s rate path at all,” she said.
Beyond the ins and outs of what rate hikes mean for a handful of regional banks that may or may not be in a pickle, SVB’s quick collapse nods to a bigger issue: the Fed’s actions are going to have plenty of ripple effects across the economy, some of which could do a lot of damage and could catch people by surprise.
“Everyone’s been wondering when something was going to break in the Fed’s rate hiking cycle, and this was the first one,” Konczal said. “This is just the beginning if they want to keep hiking at the rate they’ve been hiking.”
The conventional economic wisdom is that combating inflation necessitates increasing interest rates to slow down the economy which, ultimately, leads people to lose their jobs. The Fed’s been quite open that it’s looking for the unemployment rate to go up. Someone being laid off or fired may not make as many headlines as a bank collapse, but it’s still catastrophic in people’s individual lives and, if it happens on a broader scale, for the economy. Once layoffs start, it’s also hard to stop them, and the Fed can’t step in to boost workers like it has to boost the banks.
The horizon isn’t all doom and gloom. The economy could still see a soft landing without being pushed into a recession, and the labor market could, perhaps, slow down without millions of people being pushed out of work. The SVB crisis could also lead banks to tighten lending terms and standards, meaning the Fed could decide to raise interest rates less than it thinks to accomplish its objectives for bringing down inflation, said Donald Kohn, former vice chair of the Fed, in an email.
But for months, it’s felt like something terrible might just be lurking around the corner in the economy, even if nobody can quite put their finger on what. SVB’s downfall is a reminder of just how quickly the tides can turn, and how unanticipated they can be. In fighting inflation, this may not be the only thing the Fed breaks.
“It’s in the nature of financial events to unfold quickly,” Ricks said. “No one can tell you with any certainty, no one can tell anyone with any certainty, that there’s not another shoe to drop here.”
