Banking crisis has ‘definitely’ tipped the U.S. closer to recession, warns top Fed official who was at the center of the 2008 bailout

Capital markets have been freezing the banking sector’s perceived weaker regional lenders out of the credit system, he argued, starving them of access to liquidity and increasing the chances that economic activity would shrink, potentially to the point of a recession that, in the words of the Wall Street Journal‘s Nick Timiraos, has been predicted to be about six months away for well over a year now.

“Not all of these stresses are behind us. I expect this process will take some time,” Kashkari told CBS: Face the Nation on Sunday. “Sometimes it takes longer for all the stresses to work their way out of the system … we know that there are other banks that have some exposure.”

Kashkari, one of this year’s four rotating regional Fed presidents that casts a vote on the FOMC policy-setting committee, is a veteran of financial crises. The native Ohioan first rose to prominence at the age of 35 after then-Treasury secretary Hank Paulson handpicked him in October 2008 to administer the $700 billion in U.S. taxpayer money to bail out banks under the Troubled Assets Relief Program, or TARP. The two had worked together at Goldman Sachs, where Paulson was the CEO but barely knew the investment banker Kashkari, per the Washington Post. He stayed on at Treasury at the request of Obama appointee Timothy Geithner, and later ran unsuccessfully for California governor as a Republican, and also worked under the bond investing giant Pimco.

While Kashkari has argued repeatedly in the past for interest rate hikes, he now considers it too soon to make any forecast about the further path of interest rates with the crisis only two weeks old.

“We’ve seen the capital markets have largely been closed for the past two weeks—if those capital markets remain closed, because borrowers and lenders remain nervous, then that would tell me this is probably going to have a bigger imprint on the economy,” Kashkari explained. 

On March 22, the FOMC attempted to please hawks and doves, hiking the fed funds rate to combat inflation but only by a quarter point citing a tightening of credit conditions due to the onset of the crisis. While chair Jay Powell said the committee did not currently foresee any rate cuts during the year, investors already have begun pricing in a 74% chance the Fed will cut rates by at least 1.25% by the end of 2023, according to CME Group.

SVB-linked losses could amount to nearly $2 trillion across the system

Silicon Valley Bank sparked the current crisis after clients pulled a grand total of $56 billion out of the lender within a matter of weeks, wiping out a third of its deposit base. Two days after SVB became the second-largest lender by assets to fail in U.S. history, it was followed by the third largest, NYC-based Signature Bank.

Investors are now afraid the sector suffers unrealized losses lurking in their hold-to-maturity bank book. The Federal Deposit Insurance Corporation has estimated this risk amounts to $620 billion across the entire industry. Others believe the losses could be as high as $1.7 trillion once you factor in loans.

“The losses from the interest rate increase are comparable to the total equity in the entire banking system,” researchers at New York University wrote on March 13.

Although Kashkari claimed that deposit outflows from regional lenders have slowed in recent days and the broader sector was sufficiently capitalized to withstand the current credit crunch, he speculated that this crisis “definitely brings us closer” to recession. 

Large banks that depositors deem too big to fail are siphoning off funds from smaller ones

Banks like Citigroup, meanwhile, are claiming the problems are down to a few bad apples that failed to hedge the interest rate risk in their asset portfolio. Recently, a number banded together to deposit a combined total of $30 billion into troubled San Francisco-based peer First Republic Bank in a bid to boost confidence in the overall sector and demonstrate their still sizeable firepower.

The contagion has nonetheless already spread to Europe, claiming Credit Suisse as its first victim. On Friday, German chancellor Olaf Scholz was forced to express confidence in the country’s largest lender, Deutsche Bank, after its shares plunged as much as 15% despite annual net profits reaching a 15-year high. 

The crisis has also brought back memories of the highly unpopular bank bailouts following the 2008 collapse of Lehman Brothers. The failure of SVB and Signature Bank has sparked a fierce debate over whether taxpayers will once again be forced to rescue the U.S. banking system through another program like TARP.  

For instance, Credit Suisse is set to be swallowed up by cross-town rival UBS in a controversial emergency takeover sweetened with the help of 9 billion francs ($9.8 billion) in potential taxpayer assistance and a further 200 billion francs in government liquidity guarantees.  

TARP veteran Kashkari said he is convinced that larger banks are siphoning off their customer deposits from smaller peers thanks to an implicit belief they are too big to fail, and he is pushing for new changes to banking oversight as soon as the dust settles on the current crisis.

“This question is now beyond doubt,” Kashkari told CBS on Sunday. “Once we get through this stress period, we have to come up with a regulatory system that both ensures the soundness of our banking system, but is also fair and even so that community banks and regional banks can thrive. We do not have that today.”