13 March 2023, US authorities have announced the full backstopping of depositors at SVB Financial, while also implementing a new system-wide lending program to ensure that banks can meet requests to withdraw deposits. Many will remember from the global financial crisis (GFC) that it was full deposit insurance that was ultimately required to halt deposit flight and, as a result, this action should stem the emergence of systemic risk for the time being.
However, the failure of SVB is a consequence of something much bigger. Over the past 12 months, we have been rapidly exiting from a false equilibrium that began to form in the years after developed world economies emerged from the GFC. A false equilibrium is a theoretically unstable or unsustainable situation that has been so long lived that it appears to be a true equilibrium. The false equilibrium here is the decade and a half of excessively easy money, through near zero or negative interest rates and quantitative easing.
Policy makers have, for some time, set policy far too loose relative to prevailing economic fundamentals, evidenced by the material appreciation in asset prices over the period. Policy makers have been willing to “pivot” or add stimulus at any sign of a wobble, seeking to minimise economic and market volatility. Such action has increased confidence and deeply embedded this false equilibrium in the decision-making processes of many households, corporations and even governments. Unfortunately, history shows that even relatively short periods of mispricing the cost of money can lead to capital misallocation with economic participants taking more risk than they should, with tolerance for leverage, duration and illiquidity risk all increasing during such periods.
By their nature, false equilibria cannot last forever. The doubling down of easy money during and post the pandemic ultimately created inflation, which broke the condition required to maintain the false equilibrium. Over the past 12 months several major central banks have, after a slow start, moved quickly to fight inflation and as a result, we have moved rapidly away from an environment that had become normality and the assumed equilibrium for many.
The most speculative “investments” of the prior cycle have already come under substantial pressure, whether it be crypto currencies, NTFs, SPACs or unprofitable technology companies. We are now beginning to see early signs of businesses that built their operating models around the false equilibrium begin to struggle, such as SVB Financial. Beyond this, we see material imbalance in household leverage and housing markets in several countries around the world beginning to consolidate. We also see evidence of zombie companies. Then there are the things we can’t see yet, which have a habit of floating to the surface as the rising cost of money and slowing growth begin to place pressure on cash flows.
Economic cycles tend to be characterised by the growth of imbalances or excesses during the expansion, followed by their cleansing during recession. The false equilibrium of the past decade has created obvious imbalance and excess, and inflation has clearly broken the condition required to maintain it. The failure of SVB is a consequence of something much bigger and is likely to be the beginning of a broader delinquency, default and bankruptcy cycle rather than the end.