March 2024 is making investors nervous. While a major program to support the U.S. banking system is coming to an end, a second one may be coming to an end, too. Some economic commentators are concerned about a repeat of the banking crisis. So how worried should we be?
Red Letter Day is March 11th, when the Federal Reserve, the U.S. central bank, will end the Bank Term Financing Program (BTFP), which was launched in response to the failures of local banks Signature, Silvergate, and Silicon Valley, after one year. It's day. These banks collapsed when customers withdrew their deposits en masse. That's because many were tech companies or crypto businesses that needed money to cover losses, and there were better savings rates elsewhere.
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This hurt banks' profitability at a time when their balance sheets were already weakening as rising interest rates reduced the value of their government bond holdings. Silvergate was the first to fail, but the failure of Silicon Valley Bank on March 10 was particularly memorable. After being forced to sell bonds at a loss, it announced it needed to raise capital, sparking a bank run.
The collapse of Signature and Swiss bank Credit Suisse soon followed, and it had to be acquired by neighboring bank giant UBS. Credit Suisse has had long-standing problems, but growing anxiety amid the turmoil in the United States has been the decisive blow.
How BTFP works
Investors then feared that other banks would fail. Most U.S. banks were similarly exposed to customer withdrawals and underwater bond portfolios, but the Credit Suisse collapse showed the potential for contagion. The Fed's BTFP ended the panic by allowing U.S. banks to borrow from the central bank using bonds as collateral.
Not only did this give them access to more funds secretly, but the system also set the price of the bonds at their original face value rather than the market price. This effectively canceled out interest rate increases and re-inflated bank balance sheets. Since then, San Francisco's First Republic Bank has been the only bank to go bankrupt.
So what happens when BTFP closes? I don't think there will be any more bank failures. Banks have another year to adjust to higher interest rates and can borrow from the Fed through a separate facility called the discount window.
Nevertheless, the closure of BTFP is likely to increase borrowing costs for banks, which means their profit margins will fall. These companies may respond by raising lending rates or reducing the amount of credit available to customers, which could weaken the economy. This, combined with a second foreseeable change, could pose new risks to the sector.
Quantitative tightening
The second change relates to quantitative easing (QE) programs by the Federal Reserve and other central banks, which roughly trace their origins to the 2007-2009 global financial crisis. Central banks essentially created new money and used it to buy government bonds and other financial assets. They added more reserves to the big street banks as part of this process, which in turn allowed these institutions to lend more money.
The latest round of quantitative easing began in March 2020 in response to the pandemic and ended in 2022 when central banks began a reverse program called quantitative tightening (QT). This involves selling bonds and other assets and removing the proceeds from the financial system.
This should be a drag on the economy, but its impact has been mitigated by a system known as overnight reverse repurchase agreements or “overnight reverse repos.” This essentially allows financial institutions to park their surplus cash with the central bank overnight in exchange for government bonds. They earn additional money with very low risk and inject more liquidity into the system.
This system was very popular during the era of QE and ultra-low interest rates. This is because a large amount of cash has been injected into the system. Its use has declined since late 2022 as central banks lend out fewer bonds and institutions have less money to park overnight.
The Fed's daily balance of overnight reverse repos has fallen from more than US$2.2 trillion (£1.7 trillion) in mid-2023 to less than US$600 billion in January. However, while positive balances persist, they offset the need for the Fed to draw down reserves as part of QT. This is because some of the bonds flowing out under this system will be replaced by bonds flowing in through overnight reverse repos.
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The system can only feel the full effect of QT when the reverse repo balance reaches a very low level. At this point, the Fed has indicated it intends to slow the program and then end it.
Nevertheless, the transition could be bumpy, with banks potentially raising lending rates or reducing their willingness to lend. Many analysts expect the buffer to disappear in 2024, with predictions ranging from the end of the year to as early as March.
dangerous time
Rising interest rates have already created some of the toughest credit standards in the U.S. and the weakest demand for loans from consumers and businesses in years. Meanwhile, banks are also grappling with other major challenges, including a sharp drop in demand for office space due to the effects of working from home. This has pushed mid-sized New York Community Bank, for example, into crisis in recent weeks.
The closure of BTFPs and the end of reverse repo buffers, especially when combined, could clearly make banks even more risk-averse and profit-hungry. The danger is that all of this will damage the economy until bad loans pile up, banks become wary of lending to each other, and we run into another liquidity crisis like the one we had in 2008, when weak banks cannot survive. Thing.
Recent geopolitical tensions are an added danger. If cross-border credit and investment dry up, the risk of non-performing loans could rise further, causing bond prices to fall again, further reducing bank asset values and making borrowing more expensive.
The Fed and other central banks need to be wary of these rising risks and prepare to end QT in the near future. While the end of the BTFP is unlikely to put banks out of business, it could be one in a series of blows that could trigger a new crisis in the coming months.
Ru Xie is Associate Professor of Finance at the University of Bath.
This article is republished from The Conversation under a Creative Commons license. Read the original article.