Causal Theme: Exogenous Financial Conditions Tightening Via Deposit Flight

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Bottom Line: The current flight in deposits away from smaller banks to larger banks represents a more exogenous form of financial conditions tightening, primarily through channels affecting bank lending. The more exogenous tightening we see, the less tightening the Fed should be engaged in (all else equal). If bank lending aggressively pulls back in a more historic fashion, it may even prove necessary to reduce the Federal Funds Rate. We remain less than convinced that deposit flight dynamics and their knock-on effects to bank lending have been constrained by recent public policy measures

The failure of Silicon Valley Bank and the ongoing headlines about deposits flowing out of smaller banks (and into larger banks) has some key implications that will affect the macroeconomic outlook:

1. Smaller / regional banks will need to pay up in terms of funding cost (including higher deposit rates) for stickier deposits and more stable sources of funding. This will force capital constraints to bind in a manner that lowers their lending volumes.
2. Larger and more heavily regulated (and capital-constrained) banking institutions tend to lend less per dollar of deposits. The lost lending volume from smaller banking institutions will not be sufficiently offset by larger lending volume at larger institutions (despite seeing sizable deposit inflows). The lack of offset is also driven by the simple fact that some deposits are going to leak out of the banking system and into alternative money-like investment products (e.g. money market funds).
3. The risk capital budgets that banks (large and small) devote to lending activities are also likely to shrink amidst amplified bank fragility. Risk premiums associated with banks' cost of capital have taken the kind of structural hit that implies a major shift towards risk aversion.

All of these dynamics ultimately filter into the volume of lending that the banking system is capable of accommodating and willing to extend.  On some level, every channel described above is supposed to be part and parcel of textbook monetary transmission mechanisms. But while rate hikes have interacted with some bad risk management practices to cause the current set of dynamics, the predominant cause is the exogenous surge in deposit flows. What we are seeing now is hardly the kind of predictable or linear effect from interest rate hikes that the Fed already factored into its outlook.

An exogenous shock to funding costs and risk capital budgets should mean that monetary policy is tightened less, at the very least. If the scale of funding cost pressures and lending curtailment swelled sufficiently, the Fed should be open to lowering interest rates, to offset some of this exogenous tightening.

There has been some encouraging news of late. Discount window borrowing is on the rise and a private sector solution has been found to address the funding pressures First Republic Bank has been facing of late.

There are still outstanding concerns when dealing with the macro fallout from this episode. There is no way to be sure what constrains ongoing deposit flight, especially if it swells further over time. There is also no way to be sure that deposit flight does not lead to a precipitous drop in banks' willingness to lend. The Fed has the best real-time information for gauging both of these dynamics. They should be willing to communicate about these developments, and develop corresponding policy solutions depending on what they are observing. In the mean time, we will be on the lookout for critical anecdotes and metrics for tracking the speed of these transmission mechanisms.