Economy

The Credit Suisse Rescue Seems to Have Worked

The apparent success of the resolution of the Credit Suisse crisis leaves room for the Federal Reserve to hike its interest rate target this week.

This was less clear in the early hours after the deal for UBS to acquire Credit Suisse for around $3.2 billion was announced. Shares in markets across the globe declined, particularly for banks and other parts of the financial sector. Shares of UBS itself tumbled by as much as 15 percent as investors worried the acquirer would be dragged down by Credit Suisse.

By the time U.S. markets opened, however, the financial sector had more or less stabilized. UBS shares rose by nearly four percent. The KBW Bank Index, which tracks large U.S. banks, rose 3.11 percent. The Euro Stoxx bank index rose one percent. The S&P exchange-traded fund that tracks U.S. regional banks, which trades under the ticker KER, climbed by 4.35 percent.

First Republic Teeters on Edge of Collapse

First Republic is still in jeopardy. Shares were off by around 16 percent by midday on Monday. The New York Times reported that the San Francisco-based lender has seen roughly $70 billion in deposits head for the exits in recent weeks. That is reportedly nearly half of the bank’s total depositor base as of the end of last year. S&P Global slashed First Republic’s credit rating for the second time in a week. It looks increasingly like the rescue package put together last week will be insufficient to keep First Republic alive.

Why was the rescue ineffective? Last week a consortium of 11 banks banded together to supply a short-term loan of $30 billion to First Republic. The need for this, however, focused attention on First Republic’s reliance on short-term funding. Indeed, when Moody’s cut its rating on the bank on Friday, it specifically cited the rescue package as highlighting the shakiness of the bank’s funding.

A First Republic Bank branch in New York City on March 10, 2023. (Jeenah Moon/Bloomberg via Getty Images

First Republic has a pair of problems similar to what brought down Silicon Valley Bank (SVB)—a very high portion of wealthy customers with uninsured deposits and a very large book of securities and loans with unrealized losses. According to S&P Global, 68 percent of First Republic’s deposits are uninsured. That’s far below the SVB level of 93.8 percent but well above the U.S. banking system as a whole, where 45.9 percent of deposits are uninsured.

What’s more, First Republic also has a very high ratio of total loans plus held-to-maturity securities to deposits. According to S&P Global, this ratio was 110.6 percent at the end of last year, the highest of any bank with more than $50 billion of assets.

It is also troubling that no one has stepped forward to buy First Republic. The New York Times reported that one major bank was considering bidding for First Republic but dropped out after it conducted “deep research into First Republic’s accounts.” It likely does not help that the FDIC is still struggling to find a buyer for SVB. How many banks are out there looking to grow even larger at a time when anger at the banking system—and criticism from lawmakers—is on the rise?

The Fed Can Still Hike

Despite the ongoing troubles at First Republic, the relative calm in trading in shares of the other U.S. regional banks and the global financial system should give the Federal Reserve enough breathing room to press forward with another rate hike when it meets this week.

Certainly, the recent macroeconomic data support the case for higher rates. Measures of underlying inflation point to inflation not cooling very much at all this year. The Cleveland Fed’s metric of median CPI rose at a 7.9 percent annualized rate in February and at an 8.1 percent annualized rate in January.

It is true that some of the demand destruction required to bring down inflation is likely being accomplished by a tightening of bank lending standards, as banks pull back on credit provision to conserve liquidity. Estimates of how much tightening the banking turmoil will bring about have a wide range and are more or less guesses. It’s also not clear how long the tightening will last. If the panic lifts, banks may return to lending quickly.

Federal Reserve Chairman Jerome Powell speaks during a news conference at the Federal Reserve Board building in Washington, DC, on July 27, 2022. (AP Photo/Manuel Balce Ceneta)

Pausing would also run the risk of raising fears that the Fed might see more fragility than the market does. While everyone can see the same macroeconomic data as the Fed, the Fed has a much deeper view of the health of the banking system and of particular financial institutions. If the Fed is too worried to raise interest rates, many investors may worry that the system is less healthy than it looks.

It is also risky to send the message that the Fed can be scared off of its interest rate path by the collapse of a few banks. Pausing now would raise serious doubts about the Fed’s willingness to tighten int0 a recession, a move which may be necessary to bring inflation back down. Fed Chair Jerome Powell has spent several months trying to convince markets he can be Paul Volcker if necessary. It seems unlikely he would want to surrender all that credibility so quickly.