Banking turmoil has raised concerns of a repeat of the 2008 financial crisis, but there are significant differences between now and then.
Our Top Market Takeaways for March 24, 2023
This week tested policymakers’ resolve to calm the turmoil caused by the banking sector, while also fighting inflation. Stocks and bonds swung on every headline.
Heading into Friday, investors seemed to be taking shelter in high-quality tech companies, pushing the market higher despite volatility in both large and regional banks.
Bank stocks have underperformed the market this year
At Wednesday’s Federal Reserve meeting, the central bank raised rates by another 25 basis points (bps), bringing the cumulative total over the last year to a staggering 475 bps. Policy rates are now the highest they’ve been since 2007, and financial conditions have tightened meaningfully as a result. The banking sector is the latest to feel the impact.
From here, the banking shock should work to slow the economy, and may accelerate the path to recession. As a result, the Fed may be nearing the end of its rate hiking cycle. Its projections released this week suggest just one more hike this year. But as Chair Powell made clear, if things change and the outlook darkens, policymakers seem to have the right tools to help support the economy and financial markets if it’s needed.
Also in the press conference, Chair Powell clearly stated that the banking system was “sound and resilient.” While we wouldn’t say the current banking sector turmoil is over, we tend to agree. We may be at a crossroads in terms of monetary policy and the growth outlook, but we don’t believe the challenges we face today are like the Global Financial Crisis.
Why this isn’t the Global Financial Crisis
This latest episode of banking turmoil has reminded many of the Global Financial Crisis. Investors are concerned that the problems in U.S. regional banks and certain European lenders such as Credit Suisse are analogous to the first tremors of the crisis in late 2007 and early 2008. A similar upheaval in the financial system, deep recession, painful deleveraging and staggered recovery would obviously be very detrimental to the economy and investment portfolios.
The banking system is, and has always been, built on confidence. When confidence comes into question, it can lead to a sense of panic that feeds on itself and becomes hard to contain. It also makes this situation very difficult to forecast with any precision.
While there is tremendous uncertainty, given that the banking sector drives credit creation and subsequent economic growth, this episode is probably a negative for the market and economic outlook.
But this probably isn’t 2008, for three key reasons:
- Policymakers have tools to solve banking crises, and the bigger banks are much stronger
- The economy is in a much different place
- The magnitude of the problem is, so far, much smaller
Policymakers have the tools to solve a banking crisis, and the bigger banks are much stronger
The primary function of central banks isn’t managing inflation and employment, it is acting as a lender of last resort. In this way, central banks provide the bedrock for the banking system. The Fed’s ability to perform this role expanded during the Global Financial Crisis. It created many different types of lending facilities to provide liquidity to banks, and many former “broker-dealers” (such as Morgan Stanley and Goldman Sachs) became bank holding companies so that they could access them.
Policymakers also understand how impactful decisive action can be. The new Bank Term Funding Program they instituted the other week is designed to alleviate the pressure that banks face from unrealized losses on their portfolios of high-quality Treasury, agency and mortgage-backed debt securities. U.S. dollar swap lines are also underappreciated tools that alleviate the strain that can come from a global scramble for dollars. During the Global Financial Crisis, the U.S. dollar surged 25% in 12 months following the Bear Stearns collapse. Throughout this episode, the dollar has been falling, which signals a more sanguine liquidity environment.
While the nominal amount drawn from the Fed’s discount window (the primary facility through which banks can borrow) is concerning, it also seems to have been concentrated in the banks that are under the most stress (three of which have already failed). It usually isn’t “good” when banks are using the discount window, but it does signal that the Fed is able to serve its primary function for the financial system.
It is also clear that policymakers are trying to ring-fence the weakest links in order to arrest a downward spiral in confidence. It may take time, a more powerful form of intervention, capital raises at much lower valuations, or a combination of all three, but policymakers understand what it takes to soften the blow of a banking crisis.
Post–financial crisis regulations have required the largest financial institutions to be much less levered, better capitalized, more transparent and more liquid. The Volcker Rule prohibits banks from having their own proprietary trading and investment desks that could put depositor funds at risk. They also have lower reliance on wholesale (i.e., market-based) funding from institutional investors that is usually less sticky than standard deposits. The biggest banks are much stronger now than they were in 2008.
The big risk in the current instance is deposit flight, but that could prove to be an easier problem to solve than the core issues of leverage, mistrust between financial institutions, deteriorating credit and asset quality in the U.S. housing market, and difficult price discovery that occurred in 2008. On the other hand, profitability of the banking sector will likely be impaired as banks raise rates on deposit accounts and add debt to their balance sheets to add capital.
The economy is in a much different place
When J.P. Morgan purchased Bear Stearns from the brink of failure in March 2008, the economy had shed jobs for three straight months, and the critical construction sector had peaked a full two years earlier. Home prices peaked in the spring of 2007, and there was a tremendous glut of supply: Vacant homes accounted for almost 15% of the total housing stock.
Household and corporate balance sheets were also much weaker. Mortgage debt was a staggering 65% of GDP versus a more manageable ~45% today. Consumer and corporate debt service ratios are at secular lows.
Households had too much leverage in 2008
Over the last three months, the economy has averaged 350,000 jobs gained per month, the construction sector is still growing, home prices are only down marginally from the peak, and housing inventory is very tight.
Today, the residential real estate market that was the epicenter of the 2008 collapse is much more resilient. Credit standards are higher (the cutoff for a bottom-quartile credit score today is above 700 versus 650 in 2007), and most borrowers are locked into a low rate.
The banks that are in trouble today had concentrated deposit bases and poor interest rate risk management, not necessarily bad loans. Further, the FDIC has guaranteed the deposits of failed banks, so there has been no asset impairment (at least so far). The extent to which FDIC deposit insurance is augmented is still an outstanding question, but any action on that front could reduce the risk of further bank runs.
The growth picture going forward will probably be challenged as banks pull in their horns to manage through this shock, but this economy looks very different from the one that existed in 2008.
The magnitude of the problem, so far, is much smaller
At the time of failure, Silicon Valley Bank ($209bn) and Signature Bank (~$110bn) combined have around half the assets that Lehman Brothers (~$640bn) had. Bear Stearns (~$400bn in assets) was also larger than each. That’s not to mention the many other firms that were acquired, placed into receivership or otherwise assisted by the government (Merrill Lynch, Wachovia, Washington Mutual and AIG come to mind).*
More importantly, the interconnectedness of the system in 2008 is hard to quantify. Trillions of dollars of opaque securities with tranches and derivatives formed a knot of Gordian proportions. The 2010 Dodd-Frank Act and subsequent regulations required these positions to be registered with transparent clearing houses. From a market perspective, the financial sector was the largest weight in the S&P 500 in 2008. Today, it’s ~13% weight is still meaningful, but it’s dwarfed by technology (~25%).
That isn’t to say this situation couldn’t spiral into a much larger problem. It is to say that as of now, the magnitude and potential for contagion due to complex counterparty risk seem much smaller than they were in March of 2008. For what it’s worth, the latest indications from real-time indicators of bank funding stress, searches for “deposit insurance” and similar phrases, and commentary from Fed Chair Powell suggest that deposit outflows have stabilized.
Most importantly, the fundamental nature of this problem is different.
The Global Financial Crisis was driven by price declines in low-quality assets with poor disclosure, leading to a solvency crisis. This episode has been driven by price declines in high-quality assets with pristine disclosure, leading to a liquidity issue.
Stick to your plan
This spate of banking stress is likely to drag on growth, and raises the (already elevated) probabilities of a recession later this year. Even if market volatility subsides in the coming weeks and months, banks will probably lend less. Less credit flowing into the economy means lower growth. We are particularly worried about the linkages between regional banks and the commercial real estate sector (especially office). On the other hand, it probably means less restrictive Fed policy and lower interest rates, which could lead to a further boost for the residential housing market.
But this seems like a very different situation than the Global Financial Crisis. Then, oversupply in the housing sector, poor underwriting standards, overleverage and interconnectedness combined to create a downward spiral for asset prices and the economy. Today, we are dealing with banks whose high-quality bond portfolios have lost value, depositors who can move their cash quickly, and the threat of impaired profitability for smaller banks as they raise deposit rates to compete with larger ones.
Markets, for their part, are already pricing in a materially weaker outlook for banks. In fact, the relative performance of banks versus the rest of the market is already commensurate with the experience of both the Savings and Loan crisis of the early 1990s and the Global Financial Crisis.
Investors should rely on steady hands to guide their long-term portfolios, and focus on investments that can protect through a downturn. This banking turmoil has references to 2008, but it probably isn’t a shot-for-shot remake.
*Those numbers are also in nominal terms. If adjusted for inflation it would only emphasize how much smaller Silicon Valley Bank and Signature Bank are than Lehman and Bear Stearns).
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