Vishy Tirupattur: Liquidity, Regional Banks and Potential Regulation

As the banking sector is in the news again, investors wonder about an increase in borrowing from the Fed and possible restrictions on the horizon.

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Welcome to Thoughts on the Market. I'm Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the ongoing tensions in the regional banking sector. It's Monday, May 1st at 2 p.m. in New York.

At the outset, I would note that the news we woke up to this morning about JP Morgan's acquisition of First Republic is an important development. As Betsy Graseck, our large cap banks equity analyst noted, as part of this transaction JP Morgan will assume all $92 billion remaining deposits at First Republic, including the $30 billion of large bank deposits which will be repaid in full post consolidation. We believe that this is credit positive for the large cap bank group, as investors have been concerned that large banks would have to take losses against their $30 billion in deposits in the event First Republic was put into FDIC receivership.

That said, we will be watching closely a key metric of demand for liquidity in the system, the borrowings from the Fed by the banks. The last two weeks saw consecutive increases in the borrowings from the Fed facilities by the banks, the discount window and the Bank Term Funding Program. That the banking system needed to continue to borrow at such high and increasing levels suggested that liquidity pressures remained and may have actually been increasing over the past two weeks. In light of the developments over the weekend, it will be useful to see how these borrowings from the Fed change when this week's data are released on Thursday.

Last Friday, the Federal Reserve Board announced the results from the review of the supervision and regulation of the Silicon Valley Bank, led by Vice Chair for Supervision Michael Barr. The regulatory changes proposed are broadly in line with our expectations. The most important highlights from a macro perspective include the emphasis on banks management of interest rate risk and liquidity risk. Further, the report calls for a review of stress testing requirements. The Fed is now proposing to extend the rules that already apply to large banks now to smaller banks, banks with $100 billion to $700 billion in assets. These changes will be proposed, debated, reviewed and these changes will not be effective for a few years because of the standard notice and common periods in the rulemaking process.

What are the market implications? We think that the recent events in the regional banking sector will cause banks to shorten assumptions on deposit durations, while potential regulatory changes would likely impact the amount of duration banks can take on their asset side. This is a steepener for rates, negative for longer duration securities such as agency mortgage backed securities and a dampener for the bank demand for senior tranches of securitized credit. While the implementation of these rules will take time, markets would be proactive. In the near-term, the challenges in the regional banks sector will likely result in lower credit formation and raise the risk of a sharper economic contraction.

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