Recent events have put U.S. policymakers from the administration to Congress and the Fed in a bad light. What went wrong and what fixes can be made?
June 1, 2023
By Atul Bhatia, CFA
In July 2012, the eurozone was in crisis. Large fiscal imbalances had led bond yields to rise, driving speculation that the currency union would fall apart. At the height of the crisis, Mario Draghi, then-chair of the European Central Bank, famously remarked, “Within our mandate, the ECB is ready do whatever it takes to preserve the euro. And believe me, it will be enough.” Draghi – in coordination with political leaders – backed up his words with concrete policies to stabilise markets. The measures worked, the euro stabilised, and the crisis passed.
In 2008, U.S. officials failed to produce a comparable soundbite, but they followed the same policy playbook: clear goals and decisive action designed to unambiguously draw an end to a crisis.
Unfortunately, we believe U.S. officials have forgotten those fundamental lessons. Instead, we see their recent actions as amplifying uncertainty and creating potential future risks. While we believe there is still ample time for policymakers to make fixes, we believe investors need to be cognizant of the long-term implications of what we believe are recent policy mistakes.
Following the failure of Silicon Valley Bank (SVB) in early March, the Federal Reserve announced the creation of the Bank Term Funding Program, a way for banks to borrow against the face value of their government bond holdings and not their current market value. The difference between the market and redemption value of SVB’s bond holdings had been a major contributor to the bank’s rapid failure.
One interpretation of this move was that the Fed was repeating its actions of 2008 – quietly using policy moves to communicate resolve to the market. In this case, the central bank would have been signaling to investors that it would not allow banks to fail if management had made sound credit decisions. After all, central banks were formed in part to prevent those types of failures by providing emergency liquidity against good assets.
An alternative interpretation was that the central bank was adrift and its move was driven only by expediency and the need to issue a press release, not a considered policy response.
Like many investors, we believed the former interpretation. But that was incorrect.
The collective misreading of the Fed’s actions was evident during the failure of First Republic Bank. First Republic, like SVB, held assets that deteriorated in value as interest rates rose. Instead of government bonds, however, its portfolio was heavily weighted in residential mortgages. Was there a difference in portfolio risk between SVB’s government bonds and First Republic’s over-collateralised mortgage loans made to high-net-worth households with outstanding credit scores? Absolutely. Is the difference so stark that it is readily apparent that SVB’s bond-style investments deserved a special Fed rescue programme but that First Republic’s mortgage loan portfolio warranted the bank’s failure? That’s debatable, in our view.
The Fed’s failure to communicate any rationale for the apparent bait-and-switch to the market, sending a lifeline to certain sound credit decision-makers but abandoning others, puts its credibility at risk. We are concerned that in an inevitable future crisis, investors will look to the fine print of Fed programmes instead of seeing a commitment to do “whatever it takes.”
Line chart showing the use of the Fed’s Bank Term Funding Program in both absolute and relative terms, as it grew from $11 billion on March 15, 2023, to $91 billion by May 24, 2023, which represented growing from 0.14% to 1.09% of all Fed assets. The chart compares that growth to the fall in First Republic’s share price from $122 on March 1, 2023, to $0.30 as of May 24, 2023.
Source – RBC Wealth Management, Bloomberg; data through 5/24/23
An even graver mistake, we believe, was made by Treasury officials as they dealt with the fallout of SVB’s failure. Government officials took great pains to point out that investors would receive no assistance, even as depositors were retroactively protected on millions of uninsured assets.
To be clear, there are incredibly strong arguments in favour of the government’s stance. Investors, we believe, should reap the consequences of their decision-making, and bailouts create a moral hazard and often sow the seeds of the next crisis.
But we also believe the government’s stance is a change from investors’ existing reasonable expectations. During the 2008 financial crisis, investors in most banking institutions did not suffer permanent losses even as the government pumped in billions of dollars to support the financial system. Our concern is that policymakers have failed to consider the implications of their new stance.
With a potential total loss now on the table, investors may rationally demand higher yields for their non-deposit bank investments, and they will likely also look to exit their holdings faster if concerns rise. Banks can, of course, pay higher coupons on their bonds to attract investors, but will that level make economic sense? After all, banks will eventually need to make a loan at a higher rate to pay off bond holders. At some level, they will likely decide the additional funds can’t be justified and the banks will be forced to commensurately reduce their lending activities. Faster exits may be rational for an individual investor, but it can also lead minor problems to magnify and spread more quickly.
We are concerned the Department of Treasury – while reaching for the no bailouts sound bite – has created conditions that undercut the overarching policy goal of a stable and resilient banking system. We are confident that regulators and legislators will eventually put forward a coherent plan, but we are concerned that so little forethought goes into the implications of policy pronouncements.
Policy mistakes have not been confined to banking. The turmoil associated with raising the U.S. debt ceiling has not, in our view, been helpful to the economy or investors.
Whatever one’s political beliefs, our view is that the process of making fiscal policy has been weakened by recent events. Even if this round of negotiation leads to smart fiscal moves – and we take no position on that – the ability to fundamentally alter government budgets in a rapid, opaque, and difficult-to-predict process is not helpful to anyone.
Will future debt ceiling increases be accompanied by large increases in personal or corporate income taxes, for instance? Or will new waves of permit requirements be introduced at a future negotiation? Investors, individuals, and corporations order their financial lives based on reasonable expectations of the rules of the game. Stability and predictability have real value and that value has been tarnished, in our view.
The most powerful tool policymakers have is their ability to drive investors and economies using words to signify intent, and the power of those words boils down to credibility. We are concerned that recent events have cast U.S. policymakers in a less-than-ideal light, leading to questions on their degree of commitment – and degree of forethought – as they engage in critical decision-making.
We want to talk about your financial future.
This publication has been issued by RBC’s Wealth Management international division in the United Kingdom and the Channel Islands which is comprised of an international network of RBC® companies located in these jurisdictions and includes RBC Europe Limited and Royal Bank of Canada (Channel Islands) Limited. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by RBC’s Wealth Management international division.
This publication has been compiled from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgements as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, the value of investments and income arising can go down, future returns are not guaranteed, and an investor may not get back the amount originally invested. Countries throughout the world have their own laws regulating the types of securities and other investment products and services which may be offered to their residents, as well as the process for doing so. As a result, any securities or services discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law none of the entities which comprise the international division of RBC Wealth Management nor any of their affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of RBC Wealth Management.
Clients of RBC Europe Limited may be entitled to compensation from the UK Financial Services Compensation Scheme (FSCS) if it cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. For further information about the compensation provided by the FSCS scheme (including the amounts covered and eligibility to claim) please refer to the FSCS website FSCS.org.uk. Please note only compensation related queries should be directed to the FSCS. Royal Bank of Canada (Channel Islands) Limited is not covered by the UK Financial Services Compensation Scheme.
RBC Europe Limited is registered in England and Wales with company number 995939. Its registered office is 100 Bishopsgate, London EC2N 4AA. RBC Europe Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Royal Bank of Canada (Channel Islands) Limited (“the Bank”) is regulated by the Jersey Financial Services Commission in the conduct of deposit taking, fund services and investment business in Jersey. The Bank’s general terms and conditions are updated from time to time and can be found at https://www.rbcwealthmanagement.com/en-eu/terms-and-conditions. Registered office: Gaspé House, 66-72 Esplanade, St. Helier, Jersey JE2 3QT, Channel Islands. Deposits made with Royal Bank of Canada (Channel Islands) Limited in Jersey are not covered by the UK Financial Services Compensation Scheme. Royal Bank of Canada (Channel Islands) Limited is a participant in the Jersey Bank Depositors Compensation Scheme. The Scheme offers protection for ‘eligible deposits’ up to £50,000 per individual claimant, subject to certain limitations. The maximum total amount of compensation is capped at £100,000,000 in any 5 year period. Full details of the Scheme and banking groups covered are available on the Government of Jersey’s website http://www.gov.je/dcs or on request.
Investment services offered by the Bank are not covered by an investor compensation scheme as there is currently no such scheme operating in Jersey, however ‘eligible deposits’ held pursuant to investment services may be protected under the Bank Depositors Compensation Scheme described above – for more information see the Bank’s general terms and conditions. Some of the products that the Bank might recommend to you could be registered overseas and may be covered by a local compensation scheme. Your investment counsellor will provide you with the details of any overseas compensation schemes (where applicable) at the time of making an investment recommendation.
Copies of the latest audited accounts are available upon request from the registered office. ® / ™ Trademark(s) of Royal Bank of Canada. Used under licence.