AFMC - Quick Thoughts: The Crucial Questions
2023-03-24 03:30:00 ET
Summary
- Rising rates are posing challenges to the asset side of banks’ balance sheets.
- The rapid and aggressive tightening of monetary policy will undoubtedly put some borrowers at risk.
- Stephen Dover provides answers to crucial questions to help understand the current market volatility arising from the collapse of banks.
By Stephen H. Dover, CFA, Chief Market Strategist and Head of Franklin Templeton Institute, Franklin Templeton
To help understand the current market volatility arising from the collapse of banks in the United States and Europe, Head of Franklin Templeton Institute Stephen Dover provides his answers to three crucial questions.
In moments like these when events are rapidly unfolding and investors struggle to keep up with volatile markets, it is important to step back and ask three crucial questions:
- Is a systemic financial crisis unfolding?
- Will central banks stop hiking rates?
- What actions can policymakers take to stabilize banks, financial markets and the economy?
Here are our current thoughts:
A decade of cheap funding and deposit stability had ended. Over the past decade, zero interest rates made for stable bank deposits because nothing offered a more attractive return. Following 4.75 percentage points of US Federal Reserve (Fed) rate hikes that began 12 months ago, deposit holders have choices, such as money market funds that offer more compelling returns and are nearly as liquid.
Rising rates pose challenges to the asset side of banks’ balance sheets. That became plainly evident at Silicon Valley Bank ( SIVB ) ("SVB"), where losses on unhedged bond holdings blew a hole in the bank’s earnings, leading to its collapse. Other banks may have managed interest rate risk better, but given the opacity of their holdings, their hedging strategies and their reporting, this lack of transparency is unsettling.
The rapid and aggressive tightening of monetary policy will undoubtedly put some, but not all, borrowers at risk. First signs of trouble are emerging in commercial real estate, as well as in subprime auto loans and leases. Equity investors are beginning to discount increased provisioning against write-offs of bad loans.
Recent central bank tightening could be a positive signal. The European Central Bank (ECB) hiked rates 50 basis points (bps, one basis point equals 0.1%) last week, sending a message to markets that policymakers do not think the situation is as bad as many have thought. Similarly, the Fed raised rates 25 bps this week, and also stated that it sees the US banking system as “sound and resilient.” By their actions and their words, the ECB and the Fed are trying to bolster confidence that the financial system and economy are stable enough for them to remain focused on their priority of bringing inflation down to more acceptable levels.
Depositors must be reassured . Banking crises are pernicious because once depositors question the strength of banks, rapid withdrawals quickly follow, putting at risk both weak and strong banks. In the United States, the Fed, Federal Deposit Insurance Corporation (FDIC) and Treasury have taken significant steps through expanded deposit insurance and liquidity provisions to reassure depositors. The Fed has also extended US dollar swap lines with other central banks to ensure that other countries have adequate access to dollar liquidity. Longer term, bank regulators must expand their efforts to properly supervise banks, including using new stress tests. They must also merge or consolidate failing banks where necessary. One area of particular importance is to review bank holdings of marketable securities that could be a source of future write-downs in the event of asset sales to meet liquidity needs. To bolster depositor confidence, regulators must be empowered to force changes to bank risk management practices where necessary.
Central banks must not shy away from making clear statements about cyclical risk and how banks should view the quality of their loan portfolios . Rapid and aggressive monetary policy almost always produces a recession. Central banks must apprise banks of economic risks and regulators must undertake scenario and stress-testing of loan books to assess proper provisioning policies and, where necessary, potential capitalization needs. Those examinations must be made in advance of any cyclical deterioration in credit quality.
As beneficiaries of deposit protection, banks must be adequately supervised and regulated. Increasing transparency of banking is in everyone’s interest. Greater transparency helps to stabilize the economy and financial markets.
Banks have always been, and will remain, systemically risky because of the liquidity mismatch between banks’ assets and liabilities. The onset of aggressive monetary policy tightening has increased systemic risk on both sides of bank balance sheets. When depositors are fearful, runs can be indiscriminate. Steps taken since the failure of SVB to implicitly extend deposit insurance, to provide central bank liquidity and to absorb Credit Suisse ( CS ) into UBS have calmed market fears. While the opaque nature of banking should always caution us against firm conclusions, the available information leads us to conclude that systemic risk is receding. That will allow central banks to remain focused on reducing inflation.
What Are The Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions.
Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. Buying and using blockchain-enabled digital currency carries risks, including the loss of principal.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Quick Thoughts: The Crucial Questions