Historically, a banking crisis is not a positive for equities. In fact, it’s usually pretty bad. When the banking system looks shaky, investors typically lose confidence. And with good reason.

When banks are under stress they move into a cycle of de-leveraging, de-risking and shoring up balance sheets. They lend less and are more conservative about whom they lend to and for what. When loans are approved they are offered at higher interest rates.

Less lending from the banking sector slows overall economic growth. That has a knock-on effect on publicly listed companies, even if they have an easier time than most accessing capital.

And in the worst case scenario, the collapse of a significant bank can, with Lehman Brothers in 2008 as the most recent example, lead to the implosion of the financial system and years of economic pain.

Stock markets have traditionally plunged during banking sector crises

All of which is why stock markets tend to nosedive when there is a banking crisis. Equities lost around 10% in the immediate aftermath of the failure of Lehman Brothers in 2008. 24 years earlier in 1984, the Dow Jones lost 6% when the large regional U.S. bank Continental Illinois had to be bailed out by the Federal Reserve.

And of course, the most significant domino effect of failing banks in history took place during the Great Depression, which saw Wall Street’s market capitalisation devastated by an 89% slump that played out over 3 years.

Equities have delivered gains since SVB failed and Credit Suisse was forced into an emergency merger

In March, three U.S. banks failed. Silvergate Bank and Signature Bank were heavily exposed to the cryptocurrency sector and their collapse, which never really threatened the wider banking system, could have been shrugged off by markets on that basis.

Silicon Valley Bank (SVB) was a more significant bank and its failure was different, more systemic – it had built up overexposure to low-rate government bonds that tanked in value as interest rates rose last year.

In other circumstances, SVB might have struggled through that balance sheet fragility but was ultimately done for by a bank run.  Some observers have speculated that things may well not have unfolded quite so dramatically in a pre-social media era. The run might have been avoided.

But it wasn’t and a bank well-known as a staple lender to Silicon Valley’s growth companies blew up. Shortly after SVB had perished, the 186-year-old Swiss Bank Credit Suisse was forced into a rapid emergency merger with the larger UBS by the alpine country’s regulators. The shotgun arrangement averted disaster but was a significant blow dealt to Switzerland’s reputation as a banking safe haven.

The 2023 banking crisis may not have, so far, been as dramatic as some of its predecessors but it does now have its own Wikipedia page. Nobody is saying what happened in March wasn’t, and still is, a crisis, despite efforts in some quarters to play it down.

Lessons do look to have been learned after 2008 and regulators have obliged banks to stick to stricter rules around capital buffers and ringfencing deposits from any riskier investment activity, as well as setting limits on the amount of exposure to higher-risk derivatives.

But as we’ve seen all too clearly this year, banks are still at risk if they get things wrong and enough depositors lose confidence in them over a short space of time. Things have quietened down since March and many analysts argue the risk of further contagion or new implosions that could spiral into a major systemic banking crisis is relatively low. But the banking system is still seen as fragile.

SVB was far from the only bank that had invested heavily in government debt over the past few years – assets that are now being written down considerably due to interest rate rises, leaving big holes in balance sheets.

Despite that, the S&P 500 gained 4% in March against a long-term monthly average of 0.5%. In Europe, equities gained 3% in March.

Why did stock markets rise during March as banks failed? And why do they remain buoyant?

Equity markets still don’t like banking crisis, despite the counterintuitive gains recorded by major global indices in March. So why did they rise as banks were failing or having to be rescued through hastily arranged emergency measures?

Because there is one thing they like even less – rising interest rates. And markets seem convinced that one major outcome of the tremors that shook the banking system in March is that the Federal Reserve will ease off on new rate rises this year after taking them to 5% from a record low of 0.25% early last year.

U.S. core interest rates

Source: TradingEconomics

With inflation proving stubborn, there were fears that rates would continue to rise. The Fed was prepared to risk a recession, or deeper recession, to bring inflation under control. The feeling is the banking crisis has now shifted that stance.

The presumption is that the Fed sees the contagion of the banking crisis as an even greater threat to the economy than inflation. And because it was rising interest rates devaluing bonds issued during the low rate period that compromised SVB’s balance sheet, and pitched Credit Suisse into crisis, they’ll ease back on further rises.

There’s also an argument that the banking crisis itself has undermined consumer confidence enough to slow inflation with less significant further rate rises than may have otherwise been the case.

The Economist posits that a drop in confidence is evidenced by a slump in retail trader activity since March. Retail-trading flows have been much higher and more influential to market movements since the GameStop craze fuelled by a subreddit group enticed large numbers of new, younger investors.

In early 2023, retail traders invested a net record $17 billion in equities, fuelling stock market gains and raising hopes for a sustained recovery after a tough 2022. However, market data provider Vanda, says their activity dropped drastically in the second two weeks of March after the SVB collapse. Retail investors bought just $9 billion of equities, which was the lowest value since 2020.

Markets seem confident that the banking crisis means lower rate rises or even cuts. The share prices of the giant tech companies that have been most sensitive to recent rate rises, namely Apple and Microsoft, have leapt by 7% and 12% respectively in the last month. The tech-heavy Nasdaq gained 7% in March.

That’s more than compensated for losses in the banking and some other sectors, which have suffered losses, showing investors are not ignoring the crisis.

A further piece of evidence for underlying investor unease despite overall gains fuelled by tech stocks put forward by The Economist is activity in the interest-rate derivatives market.

Derivatives dubbed “swaptions” represent a long term position on interest rate movements and are usually used to hedge investments against a losing outcome. Investors have suddenly started buying swaptions that will pay out if the Fed lowers interest rates by 2% points by December.

The level of demand for swaptions that hedge against a 2% drop in rates is such that they currently cost twice as much as swaptions paying out on rate raises to 6% or more. In early March, hedging both scenarios cost the same.

The Fed dropping rates by 2% before the end of this year would only be likely in the face of a recession and the leap in interest in insuring against catastrophe further indicates unease masked by recent market gains.

The stock market’s behaviour suggests investors think that interest rates will be held or dropped again. But that itself implies concerns for the wider economy. For now, tech sector growth is painting a picture of rising markets that may prove deceptive.

Investors haven’t ignored the banking crisis but are confident authorities will keep it contained if any evidence of delayed aftershocks emerges. And they do have concerns for the overall economy.

Markets want to be positive but are also preparing for the worst. That means early 2023’s stock market gains could prove fragile and tightly tied to interest rates and the economic backdrop. Investors will likely continue to hope for the best but might be quickly put off by anything that looks like it might threaten that hope.