SVB Collapse: Will It Provoke A Crisis?

Markets sold off last week. Two factors were at work. First, employment figures were stronger than expected, feeding into the bearish argument that interest rates must move higher to slow excess demand and inflation. And second, a regional bank with $200 billion in assets failed. While it may not be obvious, these events are connected.

Consumer spending drives the economy. But sometimes the credit cycle drives the consumer. Normally, the most important factor for consumer spending is employment. When U.S. consumers have jobs, they spend. The level of spending is influenced by many factors but the propensity to spend is so strong that consumers will even rush to make up for lost spending following periods of hesitation. It is difficult to bet against the U.S. consumer.

That said, consumers need access to credit (loans from banks) for important transactions like homes and autos. Businesses need access to capital to make investments and hire more workers. During periods of external shocks, such as during the COVID panic or in the wake of the 2007-2009 financial crisis, banks reacted to uncertainty by pulling back on lending, as evidenced by the banks' willingness to lend index published by the Board of Governors of the Federal Reserve System.

This index clearly shows caution around lending during those events and also, of more concern, today.

Ultimately, the Fed stepped in during the financial crisis to support banks and get lending going again. This was considered a success. The Fed and the administration were following the same playbook during the COVID panic but unfortunately overdid it.

Ultra-low interest rates, direct payments to individuals, the suspension of loan and other payments and other bank actions flooded the system and created excess demand. One result has been higher prices for food and services (inflation). Another result was distortion in financial markets. Flourishing crypto fraud, meme-stock mania and crazy valuations for unprofitable tech stocks were all spawned in the toxic cocktail of stimulus checks, greed and the lack of risk aversion that comes with free money.

Crypto banks should fail and meme stock investors need to be zeroed out, unfortunately. The Fed's year-long campaign to raise interest rates can be understood as directly intending to put an end to the excesses that are behind rising prices for goods and services.

Lower stock market, home and other asset prices are to be expected in this environment. There is no debate about whether the Fed will win in its effort to destroy excess demand. The debate is whether the Fed can achieve this result without throwing the economy into a deep recession.

On the one side are the optimists. The soft-landers look at current consumer and economic activity as a sign that the economy will keep going even with the impact of higher rates. Meanwhile, the skeptics are warning that Jerome Powell's efforts are yet to be fully seen and will eventually "break something."

Is the failure of Silicon Valley Bank tangible evidence of a broader, more systemic problem stemming from rising interest rates? Will its failure wreck confidence among investors in other banks or cause banks to reduce risk by cutting lending to consumers and businesses? These questions are difficult to answer, but at a minimum, this event certainly does not seem positive for lending.

If efforts over the weekend to purchase all or part of Silicon Valley Bank are successful and the majority of depositors are made fully or mostly whole, then the crisis will be averted. Calm may be restored.

Nevertheless, risks to the system from the efforts to slow the economy and fight inflation have become more apparent.

(John Zolidis is the president of Paris, France-based Quo Vadis Capital.)