Nifty tumbled on US regional banking crisis led by SVB

Summary

But the Indian banking system is now quite resilient after years of consolidation, various regulatory reforms, and also elevated NIM/NII regime

India’s benchmark stock index Nifty made a 5-month low around 16987.50 Tuesday as banks & financials, techs plunged on the concern of the spillover effect of the U.S. startup/MSME funding bank SVB (Silicon Valley Bank) and other regional bank crises. On Friday, the California-based SVB bank has been closed by the Federal Deposit Insurance Corporation (FDIC) which has taken control of its deposits and other assets. Earlier, the run-on deposits doomed the tech/start-up-focused local lender’s share sale to shore up its balance sheet amid losses from the HTM bond portfolio (mainly MBS) on higher Fed reverse repo rate. Unable to raise fresh funds, the SVB promoter was also looking for selling the bank but failed.

Eventually, after a hectic weekend effort to stabilize the global financial market before Monday's Asian session opening, U.S. Treasury, Fed and FDIC made a joint statement assuring all depositors irrespective of insured/uninsured will be safe and can access/withdraw their deposits/hard earned money; i.e. U.S. government effectively treating SVB and other regional banks as too big to fall and virtually issued Federal guarantee to ensure financial (Wall Street) stability.

Fed is effectively extending unlimited liquidity (by printing more & more) at a time when it’s itself suffering huge negative cash flow to the tune of almost -$1.1T; in his recent Congressional testimony, Fed Chair Powell admitted -$36B MTM loss (unrealized) due to higher reverse repo rate (overnight) to banks. Big U.S. banks are earning risk-free returns equivalent to $36B from Fed as Fed is absorbing excess banking/money market liquidity instead of collateral of US TSYs.

There is a huge mismatch in assets & liabilities for regional/community banks like SVB. If we only consider deposits, SVB used to lend around 57% of total deposits, while utilizing 52% on debt/bond (mainly TSYs) investments. But after COVID (2020) this ratio drastically changed; now SVB lends around 43% of the deposit while using 72% on investments/bonds in 2022, against 35% and 71% respectively in 2021. Now as Fed is hiking rates from March’21 and tightening from late 2020 (QE stopped), 2YUS bond prices tumbled from around 110 in Jan’21 to 100 today (13^th Mar’23). This 10% fall in bond prices caused a huge notional MTM loss in SVB’s bond portfolio running into billions of dollars. But as most of it falls under HTM (Hold Till Maturity) category, the bank has not considered the MTM (unrealized) loss in its PL account.

But sensing possible loss in the future and liquidity issues, big depositors like VC, start-ups which earlier deposited their excess cash for a better return, are now worried about the return of capital rather than return on capital, causing a run on bank (deposit withdrawal). Thus SVB falls into a liquidity crisis and attempted to raise fresh capital by FPO/fresh bond issuance, but it failed-resulting in the crash. Now Fed is extending unlimited liquidity to such regional community/small banks (like SVB) so that they don’t have to sell bonds/TSYs/MBS in loss to meet withdrawal pressure.

Overall, it seems that these small banks are reluctant to expand their lending business into the productive sector of the economy, which is the core function of any bank. Moreover, SVB lends mainly to local industry like Vineyard; thus there was some limitation. In any way, NIM and NII are bound to suffer for such regional community banks, lending mainly to SMEs. It also seems that the investment arm of such banks is not smart enough to manage bond portfolios effectively. But these banks are also important systematically and politically. Thus White House has no option but to bail out.

After SVB/regional banks' fiasco, the market is now expecting a +25 bps rate hike on 22^nd March and a pause. Further, some market participants are now also expecting Fed may prefer financial stability over price stability and may not even go for any hike on 22^nd March. A few market participants are also expecting rate cuts to the tune of -75 bps by Dec’23 for the sake of financial (Wall Street) stability. Thus Wall Street, Dalal Street Futures, and Gold jumped, while USD slumped Monday. All focus will be now on Tuesday’s core inflation data, which is expected to come around +5.5% vs +5.6% prior annually (y/y) and +0.4% vs +0.4% prior sequentially (m/m). Any meaningful deviation from expectations will also move the risk assets (negatively for hotter than expected and vice-versa.

Looking at the core CPI trend, it eased from +6.6% in Sep’22 to +5.6% in Jan’23; i.e. 1% decline in 4 months. At this run rate, core inflation may fall to around +4.6% by May-June’23. Thus Fed may hike by another +25 bps on 22^nd March and 3^rd May for a terminal rate of +5.25% if core CPI comes around +5.3% or low in Feb’23; otherwise, it comes around +5.5% or even +5.7%, then Fed may go for another hike of +25 bps on 14^th June for a terminal rate +5.50% and pause thereby till at least Dec’23 to bring down core CPI towards +4.00% ensuring stable economy and employment.

Apart from regional banks, Fed is itself now bankrupt, at least theoretically with a negative net worth currently around -$1.1T. As a debt manager of the U.S. government, Fed along with Treasury has to ensure lower borrowing costs, whatever may be the narrative, and thus US10Y bond yield of around 4.25-4.50% is a red line for Fed.

U.S. is now paying almost 10% of tax revenue as interest on public debt and CBO projected around 13% and 15% for 2023-24 even after assuming an average 10Y US bond yield of around 3.80-3.90%. This is a red flag for U.S. fiscal math. China and the EU’s debt interest/tax revenue is currently around 5.5%, while Japan’s is 15%.

As a debt manager of the government, every central bank including Fed has to ensure lower borrowing costs for deficit spending, whatever may be the narrative. Thus Fed will take a balanced approach to control inflation, employment, and bond yields. Fed may not allow a US10Y bond yield above 4.25-4.50% under any circumstances (recent high around +4.08%) whatever may be the narrative.

Fed also has to ensure a softish landing, if not soft (mild employment/economic recession and 2% price stability); i.e. financial and price stability at any cost, If Fed does not hike on 22^nd March for SVB/small banks crisis, it may affect its credibility and show Fed is panicking. The U.S. now needs structural banking reform along with proper regulation such as a maximum limit for HTM portfolio (in line with Indian/RBI regulation) to avert a repeat of the Lehman moment (2008 GFC).

In the U.S./Europe/Japan, as interest rates were traditionally low, NIM/NII were also on the lower side, negative for higher regulatory capital/sufficient buffer requirement to avert such banking crisis from small regional/community banks. Now banking is a deep-pocket business requiring huge buffer capital and may not be suitable for small players. Thus banking consolidation is the only way and along with that governments may also start their public sector banks with a management controlling stake. These PSU Banks may serve the requirements of small community banks as well as large banks by serving both MSMEs and large corporates.

This will ensure also fair competition and balance between private and public sector banks like in India, where the banking system is now very strong after a series of consolidations. Now there are various public as well as private banks that have physical presence all over the country to serve every section of society. For a big country like India, having a 1.40B population and 80% of them are in BPL (below poverty line) category, financial and digital inclusion is now almost complete. India now has two big PSUs and four big private banks along with some other small private/PSU and cooperative banks. As the banking sector is strategic for any country including India, the government may never convert these PSU banks into private anymore, but will try to improve service and efficiency further; naturally private banks will also follow and improve themselves.

Indian banking system/sector is now quite resilient after years of consolidation, various regulatory reforms, and also elevated NIM/NII regime; banks are now flush with excess capital buffer to avoid any U.S. types of small bank failure even in extreme stress conditions, be it for NPA or HTM/MTM bond portfolio loss.

Bottom line: SGX Nifty Future: 17100 as of 14/03/23-Pre-U.S. session

Looking ahead, whatever may be the narrative, technically SGX Nifty Future now has to sustain over 17050 for a rebound to 17300/350-500/700-775/900-18100/375 and a further 18450/555-675/19050 in the coming days; otherwise sustaining below 17000, Nifty Future may further fall towards 16850/650 and further 15795/525-15000/14450-13500/12950 in the coming days.