Experts, students weigh interest rate hikes amid bank turmoil

The Fed raised interest rates March 22, which could extend a series of bank failures.


Economists, bankers and traders from around the world had their eyes trained on the Federal Reserve Wednesday as it announced an interest rate hike of 25 basis points, despite fears it could tack onto turmoil in the banking sector.

Prior to the March 10 collapse of Silicon Valley Bank, the second largest bank failure in United States history, traders in the futures market predicted a 70% chance that the Fed would double its prevailing 25 basis point interest rate hikes of the past month. Less than two weeks — and three failed banks — later, the Fed instead had to weather concerns that any increase in interest rates at all would further destabilize the financial sector and tip the economy into a precarious state.

Markets reacted to Wednesday’s announcement with turbulence. Heavy sell-offs on both Wednesday and Friday were succeeded by small recoveries. Trading on Friday, especially, saw Deutsche Bank, Germany’s largest bank, lose 7% of its value in the morning before recovering roughly half of that by closing, stoking fears that it could be the next in line to fall. Nonetheless, Sanjay Sharma, an adjunct professor of finance, said the Fed did “absolutely the right thing” given the present circumstances.

“It’s really hard to say right now whether these 25 basis points will exacerbate the bank problem, or if it will reduce the fears of inflation,” Sharma said. “If the Fed didn’t raise interest rates, then I would be more concerned about long-term inflation. If this is a shot in the arm to fight inflation, and that is my perception, then I would say I think inflation will be more contained, but the Fed has a very, very difficult job.”

Controlling inflation has been top of the agenda for central banks around the world, including the Fed, since mid-2021. U.S. inflation currently sits slightly above 6%, below the peak of 9% in June, but well above its 2% target. However, the collapses of several regional U.S. banks, as well as the trouble that has hit Deutsche Bank and 167-year old Swiss giant Credit Suisse, have industry economists scrambling to find out whether the Fed would be overcooking its response to inflation by increasing interest rates.

Depositors are moving en masse from regional banks to perceived safer, larger banks. Experts say that in this current uncertain market, these banks are less likely to lend, which may give rise to a ‘credit crunch’: consumers with less access to cash, spend less, thus creating disinflationary pressures. Goldman Sachs wrote in an article that this will come to serve as an effective rate hike of 25 to 50 basis points, while Torsten Slok of Apollo Global Management wrote on its own website that it was worth 150 basis points.

“We’re going to feel the effects,” said Rodney Ramcharan, a professor of finance at the Marshall School of Business. “A lot of bank lending is going to slow down and inflation will begin to come down quite rapidly in the next three to nine months.”

Billionaire Bill Ackman argued on Twitter that the Fed should have stopped any interest rate hike, while Elon Musk tweeted that the “Fed needs to drop the rate by at least 50 [basis points].” Economists at Japanese bank Nomura Holdings also suggested cutting rates. Despite this, Ramcharan said that the Fed’s 25 basis point hike was a “reasonable position to take.”

“Alternatively, they could have not changed it, but I think the inflation outlook is still tricky,” Ramcharan said.

The initial share sell-off was triggered by the collapse of SVB. A key lender to early-stage businesses in the U.S., the bank fell into the hands of federal regulators after a call to raise funds backfired and rang alarm bells for swathes of customers who withdrew their cash until the bank was no longer able to pay them back.

“The collapse of SVB, at least in the startup circles I’ve been in, has definitely been a wake up call,” said Joshua Wolk, a sophomore majoring in business administration.

As SVB was falling, pressure increased on banks deemed by investors to be at a similar risk of funding pressures and illiquidity. Silvergate, the fintech- and crypto-oriented bank, failed the same day, and Signature Bank broke down two days later. The SVB and Signature crashes are now two of the three largest bank failures in U.S. history.

Fears of contagion spread beyond America. When Credit Suisse announced it had found “material weaknesses” in its financial reporting procedures, it compounded the effects and had to be rescued, with the Swiss central authority brokering a deal worth $3.2 billion for its rival, UBS, to purchase it March 19.

“The failure of Credit Suisse would have been an absolute disaster. It would have caused a real chain reaction,” Sharma said. “That’s why the central bank basically handcuffed UBS and said, ‘You’ve got to buy this bank.’”

While successful in its end result, UBS’ shotgun acquisition of Credit Suisse added further distress to the European markets. Big banks, such as Société Générale, UniCredit and, most significantly, Deutsche Bank, lost substantial share value after a controversial decision to impose the full losses of the deal onto some of Credit Suisse’s bondholders rather than its shareholders upended the norm, and even its own investor presentations, for deals of this nature.

At the behest of the Swiss regulator, investors into Credit Suisse did not lose everything. This burden instead fell onto unsuspecting Contingent Convertible bondholders who saw their positions, worth a total $17 billion, wiped out — a move that brought uncertainty to European bond markets. While CoCo bonds were trading at nearly 78% of face value in early March, they have most recently been trading at single-digit prices.

The situation has opened itself up to criticism about CoCo bonds, Sharma said. He said he doesn’t think “there’s any point in having them at all.”

CoCo bonds date back to the Great Recession of 2008, after which taxpayers were made to pay billions of dollars in bank bailouts. European financial institutions created a new high-yield, high-risk bond that could be issued by a bank and divert the risk onto bondholders. When a bank’s capital falls below a certain threshold, the bonds automatically convert into shares of that bank. Sharma likened it to “seeking insurance when your house is already burning.”

“Banking is a confidence-sensitive sector,” Sharma said. “If you are going to shatter that confidence by calling on CoCo bonds, you are going to be a train wreck.”

Ramcharan said he also saw an opportunity for the industry to learn from the risk that bondholders have ultimately fallen to, suggesting that there may be “scope for thinking more creatively about why we have this kind of banking system.”

“Maybe we can begin to explore alternative means of getting cash for firms that are not as risky,” he said.

Ramcharan also pointed to the 2018 rollback of the Dodd-Frank Act, legislation brought in after the Great Recession to improve transparency and reduce risk on American consumers, as a factor for SVB’s collapse.

“We need to roll back some of those regulatory changes in 2018 and put the cap at $50 billion … again,” Ramcharan said. “We’ve now de facto said that all deposits are more or less insured in the United States. The flip side of that is we need to regulate most of the banks a lot more stringently.”

While federal regulators insure the deposit a bank’s customer makes to a maximum of $250,000, regulatory filings from December 2022 indicate that more than 95% of SVB’s deposits were uninsured. However, three major federal powers — the FDIC, Fed and Treasury — issued a joint statement a few days after the bank’s collapse to ensure all deposits would be made whole.

Within that statement, officials tried to calm investor panic surrounding the industry, calling the U.S. banking system “resilient” and “on a solid foundation, in large part due to reforms that were made after the [2008] financial crisis that ensured better safeguards for the banking industry.”

Wolk said SVB’s collapse and the ongoing situations at First Republic Bank and elsewhere give “a very good sign that whatever the current regulations are, are just clearly not sufficient.”

“SVB gained a lot of popularity for how lax it was about banking rules for startups,” Wolk said. “Typically, it is very difficult to work with a bank just because of all the regulations, but this is definitely a reminder of how high-risk startups are and why it’s good to operate as lean as possible.”

First Republic Bank, which has a similar business model to SVB, has been a particular point of concern for investors. It lost 89% of its share value this month, as of Monday. Eleven larger banks deposited $30 billion into First Republic as a show of confidence in the firm, and the news of SVB’s acquisition by First Citizens Bank saw regional stocks rally on Monday opening.

In light of rising stock prices, which indicate investor’s restored confidence in the financial sector, Ramcharan suggested that the financial turmoil is not yet a crisis. Rather, he characterized them as “isolated” events against a backdrop of general stresses in the banking sector that are “manageable.”

“The system is fragile, in the sense of these losses now, but it’s not necessarily insolvent,” Ramcharan said.

Correction: A previous version of the deck misstated the date that the Fed increased interest rates. It was March 22, not March 16.
Correction: The Fed’s interest rate hikes prevailed for the past month, not the past 12 months.

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