Perspectives on Systematic Risk
Author: Wiehan Dul, Investment Analyst
With $209 billion in assets, the collapse of Silicon Valley Bank (SVB) constitutes the second-largest bank failure in the history of the United States (Fig. 1). It should be noted that the collapse of SVB was not driven by credit risk but rather by interest rate risks that remained unhedged on the banks’ balance sheet. The bank realised losses of $1.8bn on its holdings of mortgage-backed securities and long-duration Treasury bonds and planned to raise $2.25bn in additional funding to shore up its liquidity position. Unrealised losses were approximately $16bn at the time. The banks plan to raise the additional funding failed as depositors lost confidence in the institution and initiated a flood of withdrawal requests.
SVBs client base consisted of mainly institutional depositors (tech start-ups, venture capital firms, and private equity firms) with accounts exceeding $250,000 (the maximum value insured by the Federal Deposit Insurance Corporation (FDIC) at the time). A total loss of deposits in excess of the maximum insured amount would have resulted in contagion with regard to credit risks throughout the sectors and industries that SVBs clients were exposed to. To prevent systematic risks throughout financial markets, the Federal Reserve stepped in to provide a new emergency lending facility to inject liquidity into the banking system and restore confidence. Intervention by the central bank has thus far managed to ease tensions and successfully restore confidence in the financial system; however, the events surrounding SVBs collapse have posed new questions regarding the path of monetary and fiscal policy, the fight against inflation, and capital market risks going forward.
In figure 2, we plot the U.S. effective federal funds rate (policy rate) against the yield on a 2-year Treasury bond. Fixed-income markets are often monitored as a signaling mechanism that can be used to form expectations of future changes in monetary policy and financial market stress. What we observe is that the yield on a 2-year Treasury tends to track and often lead the path of the U.S. policy rate. The 2-year yield has predicted major peaks and troughs in the policy rate going back to 1985 and has fallen sharply in the aftermath of SVBs collapse. This suggests a re-pricing of terminal rates in the U.S. by the bond market in reaction to perceived systematic risks. However, this is contrary to what is required and suggested by the Fed in order to tame inflation. The Fed is facing a crisis of confidence in their ability to stem systematic risk and fight inflation simultaneously, considering both risks require opposing policy stances. Incoming data will carry significant weight in deciding the outcome of the Fed's policy stance and will need to be monitored closely.
To monitor credit market risk, we consider the spread between a basket of high-yield corporate bonds and the spot Treasury curve. The yield spread between high-yield credit and ‘riskless’ treasury bonds is considered a risk premium (the yield in excess of a risk-free rate) that should compensate an investor for assuming more risk. In figure 3, we plot the high-yield spread against the (%) of U.S. commercial banks tightening lending standards. Increased lending standards make it more difficult and costly to secure credit-based funding, resulting in rising spreads. The y-axis represents the z-score of the two series and is measured in standard deviation movements from an average of zero. Notice that spreads have remained low throughout this tightening cycle, indicating that credit risks have thus far not been realised (lending standards have tightened by two standard deviations while credit spreads remain anchored to their long-term average). The collapse of SVB caused a modest uptick in spreads, as would be expected; however, this did not signal significant financial stress.
Next, we consider the effects of tighter lending standards and rising spreads on equity markets. In figure 4, we plot the high-yield spread against the S&P 500. We have once again scaled the series to help better interpret their relationship. We notice that there is a significant correlation between equity market drawdowns and rising credit spreads. Widening spreads signal market stresses that tend to spill over into other capital markets. This is also due to increased interest rates and lending standards that make safe-haven treasury bonds more attractive to investors relative to risky equities and corporate credit. We suspect that because spreads are expected to rise, this may result in further equity market volatility and drawdowns. Once again, the Fed's policy stance going forward will have a material effect on market outcomes.
Lastly, in Figure 5, we plot bankruptcy declarations in the eurozone. It is interesting to note that bankruptcies in the transportation and storage sectors were already elevated before the pandemic, which likely contributed to supply-chain constraints and the inflationary impulse associated with them. Bankruptcies in the accommodation and food services sector began rising during the pandemic and have thus far not recovered, while bankruptcies in other sectors have ticked up markedly since the beginning of 2022, which hints towards economic weakness given inflationary and interest rate pressures. A continued rise in bankruptcy declarations may hint toward future systematic risks; however, as has been noted, these risks have yet to truly emerge. We will continue to monitor incoming data closely to better inform our expectations and tactical positioning through time.
Wiehan Dul is an Investment Analyst at Amity Investment Solutions. He holds a Masters in Economics and assists the team with macro-economic research. Wiehan is also part of the Investment Committee.