Author
Executive Summary
In order to preserve anchored inflation expectations, central banks must bring inflation back down to their targets in a reasonable period of time.1 But price stability (and, in the case of the Federal Reserve, maximum employment) is not the only objective central banks must aim to achieve. Ensuring financial stability is also a primary responsibility for central banks because financial crises can cause great hardship to Main Street.
Managing inflation and achieving financial stability are usually distinct and often complementary goals, where central banks’ limited policy tools can simultaneously work to support both objectives. But these goals can come into tension at times, creating a dilemma for policymakers to decide which objective to prioritize.
In recent months, such a tension arose when some regional banks in the U.S. ran into trouble due to securities losses triggered by poor risk management by these firms in the context of policymakers having raised interest rates to combat high inflation. Although today the banking system overall is sound and resilient, bank stresses nonetheless could emerge again. In my view, given the risks that these banks have taken on, the outlook for some regional banks largely depends on what happens to inflation:
- If inflation falls as markets currently expect, allowing policy rates to fall, bank balance sheet pressures would likely reduce as longer-term rates fall, causing asset prices to climb.
- However, if inflation proves to be more entrenched than expected, policy rates might need to go higher, which could further reduce asset prices, increasing pressure on banks. In such a scenario, policymakers could be forced to choose between aggressively fighting inflation or supporting banking stability.
Increasing bank resilience now could reduce the chances for such a difficult tension to emerge because banks would be positioned to handle further mark-to-market losses that would stem from higher policy rates. This would minimize the risk that policymakers face a difficult choice between bringing inflation down and maintaining financial stability. However, the historical record shows that banks are unlikely to take meaningful actions to enhance their resiliency against this risk on their own, so bank supervisors should use their existing authority to ensure all banks are prepared to withstand a higher-rate environment.
Inflation and Stability Are Typically Distinct—but Tensions Can Arise
The Federal Open Market Committee adjusts policy rates to achieve its dual mandate goals, with stability considerations typically in the background. At times, however, financial stability can become a pressing issue for policymakers, and in such times dual mandate goals may or may not be in tension with stability. For example, the Global Financial Crisis (GFC) caused unemployment in the U.S. and many economies to soar. The Federal Reserve cut policy rates to the effective lower bound and launched quantitative easing programs, which supported employment, kept inflation expectations anchored at 2 percent, and simultaneously promoted financial stability by providing liquidity to the financial system. The goals were in alignment.
However, these goals can come into tension if the high policy rates that are needed to bring inflation down trigger stresses in banks. In this case, policymakers would face a choice: Continue the fight to bring down inflation or back off in order to reduce stress on banks. Thankfully, in recent decades, such a tension has been rare in the U.S.
High Inflation Triggered Recent Stresses in Some Regional Banks; Their Outlook Depends On Inflation
Stresses emerged in U.S. regional banks in March 2023 when uninsured depositors of some banks became concerned about large mark-to-market losses on those banks’ balance sheets. Specifically, some banks, such as Silicon Valley Bank (SVB), bought a lot of Treasury and agency securities in the preceding few years and left the interest rate risk associated with those assets largely unhedged.2 As inflation climbed and the Federal Reserve aggressively raised rates to restore price stability, the mark-to-market value of those securities fell, eroding those banks’ tangible equity level, even though capital appeared adequate by regulatory accounting measures. Those concerns sparked a run on SVB and generated concerns about some other banks. Indeed, in April 2023, outside researchers published a simple estimate based on public data that suggested the U.S. banking system faced $480 billion of mark-to-market losses, representing 23 percent of the system’s tangible equity capital.3
Looking forward, if inflation falls fairly quickly as markets currently expect (see Figure 1) and policy rates then fall, the value of banks’ securities portfolios could climb, strengthening their tangible equity levels. In such a scenario the yield curve would also uninvert, which would help to restore the value of banks’ lending franchises. This is consistent with the soft landing that many forecasters currently expect.
However, if inflation is entrenched (see Figure 2), or if additional supply shocks hit the economy, policy rates might need to go higher, potentially causing the value of banks’ securities portfolios to fall further and keeping the yield curve inverted (see Figure 3). Such a scenario could be considered stagflationary, perhaps including a recession where credit losses emerge. This could trigger additional questions about some banks’ ability to meet obligations, potentially leading to further deposit flight. (See Figure 4.)
Increased Bank Resilience Would Reduce the Chance of Financial Stability Risks Materializing
The root concern about some regional banks is their level of tangible equity capital: Uninsured depositors in SVB feared the bank might not have enough capital to absorb the mark-to-market losses it was facing, potentially exposing them to the risk of not being paid back in full.
Some observers have argued that the SVB run was so large and fast that no reasonable amount of capital could have withstood it. While the speed and scale of the SVB run do appear to have been unprecedented, this misses the point: Perceptions of insufficient tangible capital triggered the run in the first place. Ensuring that banks have enough tangible capital to absorb mark-to-market losses would help to reassure depositors that their money is safe.
Increasing bank resilience now could minimize the risk that if high inflation is indeed persistent, tighter monetary policy would then trigger financial stability issues going forward.
Banks Are Unlikely to Take Meaningful Action to Increase Resiliency On Their Own
Large losses are difficult for bank management to address. We saw this problem firsthand in 2008 when banks faced substantial credit losses in their mortgage and mortgage-backed security portfolios. While central banks have the tools to address liquidity issues, they do not have the tools to address solvency issues. Bank losses must be borne by someone, ideally equity holders, then debt holders, or unfortunately in the case of Too Big to Fail scenarios, the fiscal authorities. What steps could a bank take now to address these losses?
- Raise equity. This tends to be difficult to do when investors are already aware of existing losses and share prices are already depressed. Investors typically don’t want to fund someone else’s losses, and management also faces the risk of a failed capital raise, which could further undermine confidence of both stock investors and depositors. This was the trigger for the SVB run in March.
- Sell assets. Unless the assets are sold at above-market prices, this doesn’t address the bank’s underlying tangible capital issue. Selling assets at market prices could at best limit potential further losses stemming from even higher policy rates.
- Restrict payouts (buybacks and dividends) to build capital. Many regional banks have already limited their share buybacks. Cutting dividends appears to be the only tool available to build capital quickly today, but it is unlikely management will choose this course for fear of further impairing their share prices. We saw this in 2008 when banks continued paying dividends right into the depths of the GFC. Minneapolis Fed staff have calculated that the 19 largest banks that were subject to the 2009 stress tests paid out nearly $180 billion in dividends and buybacks from third-quarter 2006 through second-quarter 2008. Those same banks then received roughly $160 billion of government capital via the Troubled Assets Relief Program (TARP).
Consider the following illustrative decision facing the CEO of a regional bank that is already facing large mark-to-market losses on their securities:
- Option A: Cut dividends to build capital. In this scenario, there is probably a 100 percent chance of a serious hit to their stock price.
- Option B: Wait it out. Per the bond markets, it appears likely that inflation falls from here and the problem goes away. But if inflation is more entrenched than expected and a downside scenario were to materialize, there would likely be a number of banks in a similar situation at the same time, probably all arguing that management wasn’t at fault and asking for support from fiscal authorities.
Would a CEO really choose option A? It is unlikely he or she would. If banks are left to make their own individually optimal choices and if high inflation proves to be persistent, there is increased risk that bank stresses reemerge and policymakers could then face a tension between the inflation and stability goals.
What Could Supervisors Do to Push Banks to Prepare for High Inflation Risks?
One way supervisors could ensure banks are prepared is to run new high-inflation stress tests to identify at-risk banks and size individual capital shortfalls. Those identified banks could then be directed to develop plans to quickly address those shortfalls, potentially including restricting payouts. By combining individual capital preservation plans with the results of a new stress test, banks and supervisors could effectively reassure the public and investors that banks have robust plans to endure a high inflation scenario. This is essentially what the Fed did in 2009 when it released the results of its inaugural stress test, which restored confidence and ultimately signaled the end of the GFC.
Observers will note that the 2009 stress test had the backup of government capital available via the TARP to address any shortfalls. Although that backup doesn’t exist now, today’s circumstances are also very different: Whereas markets in the GFC were concerned that the banking system itself was insolvent, today the banking system has, on average, much higher levels of tangible capital than it did before the GFC. The potential losses banks face today from interest rate risk appear to be more idiosyncratic than systemwide, and this high-inflation stress test would help banks prepare for a worse-than-expected scenario.
It is important to remember that if the high inflation scenario doesn’t materialize and instead inflation falls as expected, capital could then be distributed to shareholders.
Conclusion
Anchored inflation expectations have been foundational for economic growth over the past four decades. Central banks’ fight to bring inflation back to target and preserve anchored expectations must succeed. Supervisors should consider what actions could be taken now to build resilience among regional banks in case high inflation proves to be more persistent than is currently expected by market participants.
Endnotes
1 These comments reflect my own views and may not necessarily represent the views of others in the Federal Reserve System or on the Federal Open Market Committee.
2 https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf
3 Mark Jeffrey Flannery and Sorin M. Sorescu, “Partial Effects of Fed Tightening on U.S. Banks’ Capital” (April 19, 2023). Available at SSRN: https://ssrn.com/abstract=4424139 or http://dx.doi.org/10.2139/ssrn.4424139
