The second-fastest Fed hiking cycle of recent times created its first casualty in the US banking sector last week, also reawakening fears about European banks, as the dramatic changes in the fortunes of Credit Suisse show. It appears that some US banks have been guilty of too lax an approach towards portfolio diversification, resulting in a situation where the prices of all held assets were strongly positively correlated — creating a highly concentrated risk around the path for rates. With yields rising as the Fed remains hawkish, many bank investments have been falling in value. Had these losses been booked against the tier 1 bank capital, many banks would now be looking dangerously low in capital adequacy, an important solvency ratio for banks. The now infamous Silicon Valley Bank (SVB) had a -66% return on investments that, if booked, would have resulted in a capital adequacy ratio of 5.4 and not SVB’s officially stated 15.4. This does not mean that the official number was invalid: these investments are classed as ‘held-to-maturity’ and not ‘available-for-sale’, but the equity market made the implicit adjustment to SVB’s adequacy ratio and deemed the situation untenable. When large depositors followed the equity fire-sale by withdrawing their money, SVB started to turn into a failed bank. SVB was an extreme, as the chart shows; but there are a few more banks, mainly in the US, with adjusted capital ratios that fall notably below their official ones. On the bright side, the largest and most systemically important banks were more prudent with their investment portfolios, recording smaller losses. In addition, the swift response by US policymakers may have contained the accident, at least in the US. Nevertheless, these last few days serve as a reminder that ‘accidents’ do happen when central banks hike aggressively.
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