The U.S. Federal Reserve has just cut its target interest rate range by half a percent (50 basis points), a large jump by historical measures. This unusually large move signals the economy is worse off than has been widely reported, and that the central bank remains concerned about both the weakening economy and the stability of the banking system.
The Fed’s move was not surprising. The central bank is playing catch-up with a deteriorating labor market and an exhausted consumer. Fed watchers, reading the tea leaves, were certain that a rate cut would happen, and markets had gleefully priced a 50 basis point reduction into asset values well in advance of the formal announcement.
This largely uniform belief in the inevitability of a rate cut led to rising equity and commodity prices, and declining mortgage rates, in anticipation of the move. Despite the fact that both stocks and home prices were already at all-time highs, emergency action was deemed necessary.
The Fed is playing a dangerous game here. It risks reawakening the inflationary monster that only recently was lulled into a half-sleep. It knows the risks and is choosing the lesser of two evils. While never reaching its official target rate of 2 percent inflation, the Fed appears to have decided that a 2.5 percent rise in the headline Consumer Price Index was close enough for government work, and that it would rather risk reigniting inflation than allowing a recession to occur and the business cycle to run its ordinary course.
The Fed, with some justification, fears that the economy and the banking system are now too fragile to undergo a recession and further credit tightening without it triggering a full-blown financial crisis. The ostensibly apolitical Fed is also aware of the election year, and of the debt service cost imposed on a government with some $35.4 trillion of interest-bearing liabilities, the burden of which, at 5 percent interest rates, is increasing at an accelerating rate.
One expected beneficiary of lower rates is the banks that were caught off-guard by the rapid rise in interest rates over the past two years. Silicon Valley Bank (SVB) and other financial institutions with high exposures to U.S. Treasuries and other interest-rate-sensitive securities were laid low by losses in their investment portfolios. In the case of SVB and some others, this led to capital losses and investor panic.
Rates are a two-edged sword. Lower rates mean that rate-sensitive bank liabilities will go down, but so will the banks’ income on financial assets. Which goes down faster more depends on the asset and liability match of each bank. Just as some banks were caught off-guard by rapidly rising rates, others may be negatively impacted by falling rates. Perhaps seeing the writing on the wall, long-time bank investor Warren Buffett has sold more than $7.2 billion of Bank of America stock in the past several weeks.
The Fed has remained highly concerned about areas of fragility in the banking system, including deteriorating liquidity, deposit flight, worsening credit, increasing losses, and consequent reliance on government funding.
This cycle will ultimately end in a wave of defaults, which will impact bank profitability and capital levels. And we have yet to see the full fallout from banks’ exposure to the commercial real estate sector, which has never recovered from the lockdowns and the resulting shift to remote work, especially in the urban core of large cities.
Risks to the banking sector have not gone away, and a 50 basis point reduction in interest rates will do very little to address the underlying issues. Bank depositors, investors, and customers should each remain vigilant. Deposits and other funds that you may regard as “in the bank” are not necessarily yours, nor can you always trust you’ll be able to withdraw them when you want.
But what about deposit insurance? Isn’t that enough to protect bank depositors?
The FDIC’s Deposit Insurance Fund (DIF) is required to keep reserves on hand equal to a minimum of 1.35 percent of estimated insured deposits. Since 2011, the DIF’s reserve ratio has been maintained at 2 percent. Said differently, there are only two cents of reserves available for every dollar of insured deposits. As a result, 98 percent of potential insured deposit losses are not protected without government intervention.
While the FDIC is required by statute to pay out insurance funds in the case of loss on insured deposits, this is limited by its “claims-paying ability,” i.e., cash in the fund. This will not be nearly enough to cover losses in the event of a deposit run, and the regulators live in fear of this possibility.
Moreover, since the implementation of the Dodd–Frank regulatory reforms following the global financial crisis, banks can now “bail-in” uninsured deposits (generally, any account balances above $250,000) in the event of exigent circumstances (such as a bank run and depletion of capital). This means that the banks can treat the deposits as unsecured liabilities or even convert them into bank capital in the face of a systemic crisis.
We have not seen the end of the banking crisis. We may yet be in the beginning stages.
