When idiosyncratic becomes systemic: SVB and the no-fault fallout
As global markets gradually come to terms with the implications of the collapse of Silicon Valley Bank, Australian market participants agree that even the world’s better regulated banking sectors – and wider credit markets – will feel ongoing negative consequences from what most believe to be an idiosyncratic risk event. The bank failure brought a promising start for credit issuance in Australia to a screeching halt and while there are hopes for rebound in due course it will likely be on a more fragile basis.
Laurence Davison Head of Content KANGANEWS
Additional reporting by Jeremy Chunn Editorial Consultant and Kathryn Lee Staff Writer KANGANEWS
The initial response to Silicon Valley Bank (SVB)’s collapse was fear of contagion in the US banking system via a run on deposits. Systemic risk appeared to have been contained by the start of the Australian trading day on 15 March but there is little or no expectation of a quick return to the previous level of market confidence.
Even without immediate contagion, the lingering question for market participants is whether SVB is an idiosyncratic event or the harbinger of wider issues caused by the rapid tightening cycle. Global markets have fundamentally repriced around the expectation of a shallower US rate hiking cycle, on the basis that while SVB may have been uniquely poorly placed to handle a liquidity squeeze, others will likely follow.
Although the market has settled somewhat from the febrile atmosphere of 13-14 March, when near-term contagion in the banking sector carried a higher probability factor, credit spreads have widened and sentiment weakened. Issuers contemplating new deals can certainly no longer count on the conducive backdrop that characterised the market from the start of the year through to the SVB news breaking.
On the other hand, some market sources say the bulk of new issuance in the near-term execution pipeline had already printed, with just a handful of mandates put on hold as a result of the wave of volatility. The biggest casualty in the Australian credit market may be the least related sector: hopes were high of a rebound in true corporate issuance after a dismal 2022, but SVB may have thrown a spanner in the works of deal flow just as corporate borrowers were engaging with capital markets after reporting season.
“There is a huge outstanding question about the Dodd-Frank rollback and the difference between regulatory oversight of large and small US banks. In short, the market is asking how it should – and how it can – value banks that clearly have large difference in their ALM profiles, and the ways these are regulated.”
US BANK WEAKNESS
Australian market sources universally agree that SVB was an outlier in its business model and that the warning signs of disaster would almost certainly have been picked up had it been subject to tighter regulatory scrutiny. One intermediary describes SVB as having “the classic recipe-for-disaster mix” of a short-term, relatively hot money funding base and long-tenor assets that were not marked to market.
The assumption is that this business model would not have survived a rigorous regulatory stress test. However, the rollback of Dodd-Frank rules under the Trump administration lifted the minimum assets threshold for a bank to be classified as systemically important to US$250 billion from US$50 billion, thus creating a loophole for a bank like SVB.
SVB had a reported balance sheet of US$212 billion just prior to its collapse and was thus not subject to the most stringent regulatory scrutiny of key metrics like its net stable funding ratio and liquidity coverage ratio. Its internal stress testing was clearly inadequate or flawed.
“There is a huge outstanding question about the Dodd-Frank rollback and the difference between regulatory oversight of large and small US banks. In short, the market is asking how it should – and how it can – value banks that clearly have large difference in their ALM profiles, and the ways these are regulated,” says Gerard Perrignon, managing director, debt capital markets at RBC Capital Markets in Sydney.
More recent commentary has focused on Australia’s more robust regulatory system even outside the domestic systemically important banks – the big four. For instance, Mark Bayley, portfolio manager at Kapstream Capital in Sydney, tells KangaNews: “The banks here are regulated differently, for a start, and banks can’t choose their regulator. Australian banks typically largely hedge interest rate risks and most of their assets are held at fair value. I don’t think there are going to be too many skeletons in the closet. We can never say never, but that’s our read of where things are at.”
Even so, the initial reaction to the SVB collapse was a generalised retreat from banks and, in particular, smaller and regional institutions. The impact was at times catastrophic in the US, with regional bank share prices hammered and at least one other institution – Signature Bank, which had an asset book of US$110 billion – also failing after a run on deposits.
The impact was smaller in Australia but still significant. For instance, Bendigo and Adelaide Bank’s share price fell by more than 8 per cent from shortly before the SVB failure to its low point on 14 March. Commonwealth Bank of Australia (CBA) shares fell by around 5 per cent in the same period. Both banks recovered more than half their lost value in 15 March trading.
In the credit market, traders report major-bank senior spreads widening by around 10 basis points out to five years in minimal trading volume on 13-14 March. However, even during the peak of uncertainty there were signs that the market was not anticipating a full-blown liquidity crunch. BBSW, for instance, remained very stable with fluctuations measured in fractions of a basis point (see table).
BBSW PRICING, MARCH 2023
|Date||3m BBSW (per cent)||6m BBSW (per cent)|
|1 Mar 23||3.5949||3.9517|
|2 Mar 23||3.6237||3.9500|
|3 Mar 23||3.6286||3.9600|
|6 Mar 23||3.6325||3.9629|
|7 Mar 23||3.6324||3.9550|
|8 Mar 23||3.6332||3.9300|
|9 Mar 23||3.6261||3.9400|
|10 Mar 23||3.6400||3.9200|
|13 Mar 23||3.6446||3.9267|
|14 Mar 23||3.6380||3.8550|
Australian market participants highlight the lack of activity more than the pricing moves. Phil Strano, senior investment manager at Yarra Capital Management in Melbourne, says: “Spreads have pushed out off the back of re-marking by brokers although that is not from a lot of transactions. It has been pretty muted, quite orderly – I don’t think liquidity is necessarily drying up. I think everyone is pretty comfortable that this is not the beginning of a financial crisis.”
Brad Dunn, Sydney-based senior credit analyst at Daintree Capital, adds: “Due to the speed of developments, the market has instinctively reacted with an initial widening of spreads in expectation of de-risking flows from real money. This is being balanced to some extent by retail investors – which have been strong buyers so far this year, attracted by all-in yields. Weight of money will likely see spreads biased wider for the next week or two while the market comes to terms with the current situation.”
“There is a good chance central banks will pause for a period. I don't know how long that period will be, but there is a good chance the market is at least partly right – that central banks could do less, because they have seen what might be a warning shot that they risk breaking the system by going much further.”
SIGN OF THINGS TO COME?
With immediate contagion in the banking sector now apparently a lower risk, the primary impact of the SVB collapse may be as a catalyst to awareness of the likely consequences of aggressive tightening by the US Federal Reserve and other central banks. SVB’s business model put it on the front line of vulnerability but there is a growing expectation that the pace of rate hiking will produce further victims in the months to come.
In short, SVB brings home the reality of global markets moving into an environment of enhanced credit risk. “The biggest issue from my perspective is liquidity,” Dunn comments. “Higher rates will make borrowing more expensive and influence corporate and consumer behaviour but, without liquidity, imbalances can emerge very quickly.”
He adds, however, that the core financial and payments system in Australia remains solid and thus the likelihood of imminent failures in Australia is slim.
In fact, SVB’s risk profile was materially higher even than its supposed peer group. An S&P Global Market Intelligence report published on 15 March notes that its market signal probability of default model gave SVB a one-year default probability of 6 per cent in December 2022, nearly five times higher than the median for US regional banks.
Even so, a 13 March report penned by TD Securities’ head of portfolio and ESG strategy, Cristian Maggio, and senior portfolio and ESG strategist, Jose Gonzalez, argues: “Was the SVB case predictable? It probably wasn't for most… But what we think was (and remains) more predictable is the consequence of an aggressive and protracted tightening cycle on the state of health of the US corporate and financial sectors.”
In other words, while SVB may have been doomed by its business model it was likely inevitable that the policy backdrop would start claiming victims. “We are at the one-year mark since the Fed started raising rates. Therefore, we are within the time range when the ‘tightening-recession cycle relationship’ has historically unfolded according to our studies,” the TD analysts write. “We also note that we expect the US economy to enter into a recession in early 2024. Hence, we argue that between now and then we should observe a progressive—albeit, at times, stealth—weakening of corporate sector fundamentals.”
This appears to sum up the market view, as there has been a significant repricing in favour of a much less aggressive tightening path in the wake of SVB’s collapse. The consensus was for a 50 basis point rate hike at the 22 March Fed meeting but this has shifted to expectations of no move or a smaller, 25 basis point, hike. Some forecasters even believe a rate cut could be on the cards.
CBA’s economists were already at the dovish end of rate expectations and the bank’s Sydney-based head of fixed income and currency strategy, Martin Whetton, tells KangaNews: “Our economic research team is looking for one more hike in this cycle ahead of a pause, before cuts are to be commenced in Q4 of 2023. The recent market moves around terminal pricing bring levels closer to our house view, here as well as in the US.”
It remains too soon to tell whether this will prove to be an inflection point for central bank policy. Strano says: “There is a good chance central banks will pause for a period. I don't know how long that period will be, but there is a good chance the market is at least partly right – that central banks could do less, because they have seen what might be a warning shot that they risk breaking the system by going much further.”
Others believe policymakers will not be distracted from their primary goal of taming inflation even if there is an apparently higher cost to be paid for doing so. “My view is generally that the Fed will still hike in March,” Bayley argues. “My expectation is that this should blow over reasonably quickly and the Fed’s focus will return to fighting inflation, which is its key mandate. I personally don't think we will see rate cuts this year. Depending on inflation, I still think we will see the Fed push through one or two more hikes.”
“We have the situation again of who wants to be the first back to market. It will take a few more days of getting through everybody’s concerns and then we will see what happens. It is almost a case of resetting the dial and giving it three, four or five more days until primary markets are even thinking about issuance again.”
The other lingering question for the Australian market is for how long this latest risk event will stall what had been a positive environment for primary issuance and, in particular, whether it will stymie a hoped-for resumption in true corporate deal flow.
Up to the SVB collapse, 2023 had provided fertile ground for Australian dollar issuance by sovereign-sector issuers – domestic and from the global supranational, sovereign and agency sector – banks and, increasingly, securitisers.
Intermediary sources say no more than a small handful of mandates have been put on hold. They note that issuance was frenetic in the weeks leading up to mid-March and flow was likely due a natural slowdown – especially with the Fed meeting and other key data prints looming, and a UK budget on 15 March.
Investors generally do not expect a rapid return to new issuance. Bayley tells KangaNews: “I think we will still see plenty of structured deals coming in the next few weeks but on the corporate and bank side we are probably still a few days away from even testing the market. We have the situation again of who wants to be the first back to market. It will take a few more days of getting through everybody’s concerns and then we will see what happens. It is almost a case of resetting the dial and giving it three, four or five more days until primary markets are even thinking about issuance again.”
Bayley notes that no other corporate issuer had followed Telstra Group’s 1 March print. Meanwhile, he argues, even as fears of systemic risk ease banks will inevitably be “fielding questions from concerned clients about exposures, whether there is anything hidden and how they mark their assets – are they carrying anything at cost rather than fair value.”
On the other hand, some market users point out that not all the market tailwinds have been dissipated by SVB. Strano says issuers may find wider spreads are better entry points for issuers and insists Yarra is still open for business – “I’m not taking my bat and ball and going home”.
Meanwhile, while one Australian syndicate banker acknowledges that there is little or no chance the local market will simply “get over this and relaunch from exactly where we were”, there is also no reason to think the issuance hiatus will be protracted. “I am confident it will return to a strong, liquid position. The market just needs to find its footing and we need to see US dollar and euro issuance get back on track. The overhang cash investors had before any of this happened is still there,” the banker says.