First Republic, SVB, Credit Suisse Show How Higher Interest Rates Caught Up with Banks

For much of the early part of 2023, the economy seemed to be humming along.

Inflation was hot, but continuing to ease. The labor market and consumer spending remained resilient. And few, if any, questioned the health of the financial system.

Then the music stopped. In a span of less than two weeks, the financial world has turned on its head, leaving investors to contemplate whether the economic expansion is nearing its end.

What began as a plight specific to one cryptocurrency-focused bank rapidly morphed into a crisis with economic, political and international repercussions. Silicon Valley Bank and Signature Bank collapsed just days after the shutdown of the crypto lender Silvergate Capital Corp. Investors have grown increasingly concerned about Credit Suisse Group AG and First Republic Bank FRC -32.80%decrease; red down pointing triangle.

The saga, still unfolding, has shattered confidence among startups and venture firms in Silicon Valley; sent regulators scrambling to stop the collapse of a few banks from turning into the demise of many more; and led to a furious sale in the stocks and bonds of financial institutions around the world.

Bankers who had largely taken for granted that clients would keep their money with them were confronted by runs that unfolded at breakneck speed. Investors who spent the past year mainly worrying about how far the Federal Reserve would take its fight against inflation are reckoning with a new set of worries: Will the fallout among regional banks be contained relatively quickly, leaving the economy largely on the same path it was on before? Or will it spiral into something bigger, as Lehman Brothers did, potentially leading to a protracted economic downturn?

It is still too early to tell. Even as of Friday, the fallout continued. Silicon Valley Bank’s parent company filed for chapter 11 bankruptcy protection, marking the largest bankruptcy filing to stem from a bank failure since the collapse of Washington Mutual in 2008.

The clearest takeaway from the past week is that many of the financial world’s assumptions about how the rest of 2023 would play out have been upended.

As recently as the start of the month, Torsten Slok, chief economist and partner at Apollo Global Management, said he believed the economy was running so hot that there would be “no landing.”

Now he and many others believe the odds of a recession have substantially increased.

“The slowdown that the Fed has been trying to achieve for so long may come a lot faster than we thought just two weeks ago,” Mr. Slok said.

In a way, the events of recent days weren’t a total surprise. Ever since central banks around the world began rapidly raising interest rates last year to rein in inflation, investors, analysts and economists have been on the lookout for signs that something in the market’s plumbing was breaking.

That is because for years after the 2008 financial crisis, interest rates were at rock bottom. That helped fuel a historic rally in risky assets. When rates rise, though, borrowing costs do too. That can put pressure on markets and cause disruptions in lending—especially when rates go up significantly in a relatively short time frame, as they did last year.

Cracks began to emerge. U.K. markets were slammed in the fall after the government said it would push through surprise tax cuts. That led to a meltdown in complex financial instruments held by pension funds called liability-driven investments, which forced the Bank of England to launch an emergency intervention to prevent broader damage and the U.K. government to walk back the tax cuts.

Key players in the crypto market also imploded.

Until recently, there was little sense that the U.S. banking sector—home to many of the most important financial institutions in the world—was vulnerable too.

“I don’t think that anyone on Wall Street would have expected nothing to happen with rates going from around zero toward 5%,” said Johan Grahn, head ETF market strategist at AllianzIM. “Something was always expected to break. But like with everything else, before it happens, you don’t know what it will be.”

How the health of the U.S. banking system came into question

The first signs of broader trouble came March 8, when SVB Financial Group disclosed that it had been hit by a $1.8 billion loss selling investments. The California bank, which catered to venture-capital investors and technology startups, said it would try to raise capital through a stock offering.

Depositors fled the bank. The Federal Deposit Insurance Corp. stepped in to seize control of the failing bank on the morning of March 10, but by then, shares of other banks had begun to crater.

Investors quickly zeroed in on other lenders that shared some of the same traits that triggered SVB’s collapse: a dependence on uninsured deposits, or those above the FDIC’s $250,000 cap, and a large portfolio of government bonds and other debt securities that had fallen in value as the Fed began to raise interest rates.

When government officials failed that weekend to find a buyer for SVB, they returned to a crisis playbook with a series of emergency measures aimed at shoring up flagging confidence in the financial system. That Sunday evening, U.S. regulators said they would guarantee all of SVB’s deposits and would make more funds available to support other banks should they face a similar run on their deposits. Officials also took over Signature Bank, a major player in the cryptocurrency industry, and pledged to make all of their depositors whole as well.

Although the government’s extraordinary actions appeared to rescue customers at SVB and Signature, the crisis still threatened to spread to other regional banks. Last Monday morning, the shares of another U.S. lender, First Republic Bank, opened well below where they closed the prior Friday afternoon. This time, though, the nation’s biggest banks rode to the rescue.

The group, which included JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co., hatched a plan to flood First Republic with cash. The plan, which was discussed with Treasury Secretary Janet Yellen and other U.S. officials and unveiled Thursday, delivered $30 billion in uninsured deposits to the lender.

Many of the biggest banks had seen an influx of billions of deposits from midsize lenders in the wake of SVB’s collapse, and were effectively giving some of the money back to help another regional bank on the cusp of suffering the same fate.

The moves helped reassure some investors.

“Despite the fears of the last week, I still think the contagion risk here is somewhat limited,” said Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management.

Banks and consumers look as though they are less overleveraged than they were in the buildup to the 2008 financial crisis, Mr. Schutte said. “It doesn’t mean there won’t be some other knock-on effect…but in general, I think we’re in a much different place.”

Not all investors were convinced. The selloff in bank stocks resumed Friday after a brief reprieve the day before, with shares of First Republic sliding 33%.

Investors worry Credit Suisse could be the next to fall

The crisis spilled over the Atlantic at the start of this past week to Europe, where investors became increasingly concerned about the viability of Credit Suisse .

The Switzerland-based global bank had already been seen by many investors as a troubled lender, because of a string of scandals, big losses and withdrawals from its wealthy clients, who are key to the bank’s turnaround strategy. For years, many on Wall Street had viewed Credit Suisse as “the biggest slow-moving train wreck,” Mr. Schutte said.

Then the rout in bank stocks began, taking down not only U.S. lenders but banks around the world, including Credit Suisse.

Tuesday bought fresh turmoil. The bank released its annual report after a delay prompted by last-minute questions from the U.S. Securities and Exchange Commission and reported material weaknesses in its financial reporting over the previous two years. It also said customer outflows had yet to reverse.

Panic built Wednesday. The chairman of Saudi National Bank was asked in a television interview if he would consider topping up its investment. “Absolutely not,” he said, citing regulatory issues that would block the bank from doing so. He later said that markets misconstrued his comments and that he was fully supportive of Credit Suisse.

The damage was done. Credit Suisse shares plunged further. Bonds that are wiped out if the bank goes under dropped precipitously, a sign that investors were considering the worst.

To those inside Credit Suisse, the attention on them felt perplexing. Unlike Silicon Valley Bank, it didn’t have a big pile of unrealized losses on bonds. It was hedged for interest-rate moves. And its deposit base, while shrunken, was well-matched with ample amounts of easy-to-sell assets.

But markets weren’t buying it.

A lifeline came Wednesday evening in Zurich. The Swiss National Bank said that the problems at U.S. banks didn’t pose a threat to Switzerland, but that it would provide liquidity to Credit Suisse, if necessary.

It was necessary. Before the sun rose Thursday, Credit Suisse said it would tap up to $54 billion in liquidity, in chunks as needed. It later pledged Swiss mortgages and other assets as collateral.

There was an initial sigh of relief in markets Thursday. Credit Suisse shares jumped nearly 20%. Bond investors were unconvinced, with prices staying in distressed territory. The cost to insure against default stayed at nosebleed levels. And bankers and money managers scoured their books to see what exposure they had to Credit Suisse.

Colin Graham, head of multiasset strategies and co-head of sustainable multiasset solutions at Robeco, said his team had been getting more calls than usual from clients. Many wanted to know if their money was invested in any of the banks that had come under pressure lately.

“He told me he was relieved,” Mr. Graham said of one client who was reassured his portfolio wasn’t exposed to Credit Suisse.

Markets shudder

The banking crisis quickly reverberated throughout markets.

A measure of bond market volatility, known as the ICE BofA MOVE Index, jumped to the highest level in almost 15 years—surpassing its peak during the March 2020 market crash. The index hit levels rarely seen outside the 2008 financial crisis and the Russian ruble crisis in 1998.

Meanwhile, a measure of liquidity in Treasurys, the difference between buy and sell prices in the market, rose by more than 60% over the past month for 10-year U.S. Treasury notes, according to Tradeweb data.

At times, traders said it was tough to get in and out of positions, with trades taking longer and costing far more than they typically would—a sign that the bank tumult was causing strains in key markets around the globe.

“There’s a huge illiquidity in the corporate bond market,” said Michael Contopoulos, director of fixed income at Richard Bernstein Advisors.

Although market volatility ratcheted up and bank stocks plunged, investors refrained from pulling back from stocks broadly. The S&P 500 dropped Friday but ended the week up 1.4%. The tech-heavy Nasdaq Composite fell too, but posted a 4.4% weekly gain.

Analysts attributed the broader market’s resilience to investors holding out hope that the tumult hitting the banking sector would stay relatively contained.

Traders have piled into bets that the current crisis will force the Fed to pause its interest-rate increases soon and move to cutting rates by the second half of the year. That marks a sharp reversal from before the bank failures, when many investors widely believed the Fed would likely keep interest rates high for the rest of the year.

Some, including economists at Goldman Sachs, believe the Fed will wind up keeping interest rates unchanged at its meeting this coming week in a bid to give priority to financial stability. Others fear that, if the Fed were to cut rates too soon, it wouldn’t only prolong its task of reining in inflation but also potentially spook the markets.

“People may start to think, ‘What does the Fed know that I don’t know?’” said Mr. Grahn of AllianzIM, adding that for that reason, he believes the central bank will still deliver a rate increase of a quarter-percentage point this coming week.

What’s next

Even at the end of the week on Friday, it was unclear how much longer the bank rout would last—and how big of an impact it would wind up having on the economy.

On the one hand, investors and economists spent much of the past year anticipating that the Fed’s interest-rate increases would cause a recession, only to be proved wrong time and time again.

On the other hand, SVB’s and Signature Bank’s collapses have thrown a wrench into Wall Street’s economic outlook. If the saga leads to banks’ pulling back on lending, that could slow down spending among consumers and businesses, in turn heightening the chances of a downturn in the coming year, said Jeffrey Schulze, investment strategist at ClearBridge Investments.

Mr. Schulze added that he now believes “the economic cake is baked in regards to a U.S. recession this year, even if we get stabilization with this banking crisis.”

Wall Street’s biggest question now is who could be next.

“There’s a lot of talk about whether this will be like 2008, or if it’s just like another Orange County or Long-Term Capital Management,” Mr. Slok said, referring to episodes in the 1990s, when Orange County, Calif., declared bankruptcy following a series of bad investments and the highly leveraged hedge fund LTCM had to be bailed out by 14 banks.