Financial crashes like revolutions are impossible until they are
inevitable. They typically proceed in stages. Since central banks began
to increase interest rates in response to rising inflation, financial
markets have been under pressure.
In 2022, there was the crypto meltdown (approximately $2 trillion of losses).
The S&P500 index fell about 20 percent. The largest US technology companies, which include Apple, Microsoft, Alphabet and Amazon, lost around $4.6 trillion in market value The September 2022 UK gilt crisis may have cost $500 billion. 30 percent of emerging market countries and 60 percent of low-income nations face a debt crisis. The problems have now reached the financial system, with US, European and Japanese banks losing around $460 billion in market value in March 2023.
While it is too early to say whether a full-fledged financial crisis is imminent, the trajectory is unpromising.
***
The affected US regional banks had specific failings. The collapse of Silicon Valley Bank
("SVB") highlighted the interest rate risk of financing holdings of
long-term fixed-rate securities with short-term deposits. SVB and First
Republic Bank ("FRB") also illustrate the problem of the $250,000 limit
on Federal Deposit Insurance Corporation ("FDIC") coverage. Over 90 percent of failed SVB and Signature Bank as well as two-thirds of FRB deposits were uninsured, creating a predisposition to a liquidity run in periods of financial uncertainty.
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The crisis is not exclusively American. Credit Suisse has been, to
date, the highest-profile European institution affected. The venerable
Swiss bank -- which critics dubbed 'Debit Suisse' -- has a troubled history
of banking dictators, money laundering, sanctions breaches, tax evasion
and fraud, shredding documents sought by regulators and poor risk
management evidenced most recently by high-profile losses associated
with hedge fund Archegos and fintech firm Greensill. It has been plagued
by corporate espionage, CEO turnover and repeated unsuccessful
restructurings.
In February 2023, Credit Suisse announced an annual loss of nearly
Swiss Franc 7.3 billion ($7.9 billion), its biggest since the financial
crisis in 2008. Since the start of 2023, the bank's share price had
fallen by about 25 percent. It was down more than 70 percent over the
last year and nearly 90 percent over 5 years. Credit Suisse wealth
management clients withdrew Swiss Franc 123 billion ($133 billion) of deposits in 2022, mostly in the fourth quarter.
The categoric refusal -- "absolutely not" -- of its key shareholder Saudi National Bank to inject new capital into Credit Suisse precipitated its end. It followed the announcement
earlier in March that fund manager Harris Associates, a
longest-standing shareholder, had sold its entire stake after losing
patience with the Swiss Bank’s strategy and questioning the future of
its franchise.
While the circumstances of individual firms exhibit differences,
there are uncomfortable commonalities - interest rate risk, uninsured
deposits and exposure to loss of funding.
***
Banks globally increased investment in high-quality securities --
primarily government and agency backed mortgage-backed securities
("MBS"). It was driven by an excess of customer deposits relative to
loan demand in an environment of abundant liquidity. Another motivation
was the need to boost earnings under low-interest conditions which were
squeezing net interest margin because deposit rates were largely
constrained at the zero bound.
The latter was, in part, driven by central bank regulations which
favour customer deposit funding and the risk of loss of these if
negative rates are applied.
Higher rates resulted in unrealised losses on these investments exceeding $600 billion as at end 2022 at
Federal Deposit Insurance Corporation-insured US banks. If other interest-sensitive assets are included, then the loss for American banks alone may be around $2,000 billion. Globally, the total unrealised loss might be two to three times that.
Pundits, most with passing practical banking experience, have
criticised the lack of hedging. The reality is that eliminating interest
rate risk is costly and would reduce earnings. While SVB's portfolio's
duration was an outlier, banks routinely invest in 1- to 5-year
securities and run some level of the resulting interest rate exposure.
Additional complexities inform some investment portfolios. Japanese investors have large holdings of domestic and foreign long-maturity bonds.
The market value of these fixed-rate investments have fallen. While
Japanese short-term rates have not risen significantly, rising
inflationary pressures may force increases that would reduce the margin
between investment returns and interest expense reducing earnings.
It is unclear how much of the currency risk on these holdings of
Japanese investors is hedged. A fall in the dollar, the principal
denomination of these investments, would result in additional losses.
The announcement by the US Federal Reserve
("the Fed") of coordinated action with other major central banks
(Canada, England, Japan, Euro-zone and Switzerland) to provide US dollar
liquidity suggests ongoing issues in hedging these currency exposures.
Banking is essentially a confidence trick because of the inherent
mismatch between short-term deposits and longer-term assets. As the
rapid demise of Credit Suisse highlights, strong capital and liquidity ratios count for little when depositors take flight.
Banks now face falling customer deposits as monetary stimulus is
withdrawn, the build-up of savings during the pandemic is drawn down and
the economy slows. In the US, deposits are projected to decline by up to 6 percent.
Financial instability and apprehension about the solvency of individual
institutions can, as recent experience corroborates, result in bank
runs.
***
The fact is that events have significantly weakened the global banking system. A 10 percent loss on bank bond holdings would, if realised, decrease bank shareholder capital by around a quarter. This is before potential loan losses, as higher rates affect interest-sensitive sectors of the economy, are incorporated.
One vulnerable sector is property, due to high levels of leverage generally employed.
House prices are falling albeit from artificially high pandemic levels.
Many households face financial stress due to high mortgage debt, rising
repayments, cost of living increases and lagging real income. Risks in commercial real estate are increasing. The construction sector globally shows sign of slowing down. Capital expenditure is decreasing because of uncertainty about future prospects. Higher material and energy costs are pushing up prices further lowering demand.
Heavily indebted companies, especially in cyclical sectors like
non-essential goods and services and many who borrowed heavily to get
through the pandemic will find it difficult to repay debt. The last
decade saw an increase in leveraged purchases of businesses. The value of outstanding US leveraged loans
used in these transactions nearly tripled from $500 billion in 2010 to
around $1.4 trillion as of August 2022, comparable to the $1.5 trillion
high-yield bond market. There were similar rises in Europe and elsewhere.
Business bankruptcies are increasing in Europe and the UK although they fell in the US
in 2022. The effects of higher rates are likely to take time to emerge
due to staggered debt maturities and the timing of re-pricing. Default
rates are projected to rise globally resulting in bank bad debts, reduced earnings and erosion of capital buffers.
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***
There is a concerted effort by financial officials
and their acolytes to reassure the population and mainly themselves of
the safety of the financial system. Protestations of a sound banking
system and the absence of contagion is an oxymoron.
If the authorities are correct then why evoke the ‘systemic risk
exemption’ to guarantee all depositors of failed banks? If there is
liquidity to meet withdrawals then why the logorrhoea about the
sufficiency of funds? If everything is fine, then why have US banks borrowed $153 billion at a punitive 4.75% against collateral at the discount window,
a larger amount than in 2008/9? Why the compelling need for authorities
to provide over $1 trillion in money or force bank mergers?
John Kenneth Galbraith once remarked that "anyone who says he won't resign four times, will". In a similar vein, the incessant repetition about the absence of any financial crisis suggests exactly the opposite.
***
The essential structure of the banking is unstable, primarily because
of its high leverage where around $10 of equity supports $100 of
assets. The desire to encourage competition and diversity, local needs,
parochialism and fear of excessive numbers of systemically important and
'too-big-to-fail' institutions also mean that there are too many banks.
There are over 4,000 commercial banks
in the US insured by the FDIC with nearly $24 trillion in assets, most
of them small or mid-sized. Germany has around 1,900 banks including
1,000 cooperative banks, 400 Sparkassen, and smaller numbers of private
banks and Landesbanken. Switzerland has over 240 banks with only four
(now three) major institutions and a large number of cantonal, regional
and savings banks.
Even if they were adequately staffed and equipped, managers and
regulators would find it difficult to monitor and enforce rules. This
creates a tendency for 'accidents' and periodic runs to larger banks.
Deposit insurance is one favoured means of ensuring customer safety
and assured funding. But that entails a delicate balance between
consumer protection and moral hazard - concerns that it might encourage
risky behaviour. There is the issue of the extent of protection.
In reality, no deposit insurance system can safeguard a banking
system completely, especially under conditions of stress. It would
overwhelm the sovereign's balance sheet and credit. Banks and consumers
would ultimately have to bear the cost.
Deposit insurance can have cross-border implications. Thought bubbles like extending FDIC deposit coverage to all deposits
for even a limited period can transmit problems globally and disrupt
currency markets. If the US guarantees all deposits, then depositors
might withdraw money from banks in their home countries to take
advantage of the scheme setting off an international flight of capital.
The movement of funds would aggravate any dollar shortages and
complicate hedging of foreign exchange exposures. It may push up the
value of the currency inflicting losses on emerging market borrowers and
reducing American export competitiveness.
In effect, there are few if any neat, simple answers.
***
This means the resolution of any banking crisis relies, in practice, on private sector initiatives or public bailouts.
The deposit of $30 billion at FRB by a group of major banks is
similar to actions during the 1907 US banking crisis and the 1998 $3.6
billion bailout of hedge fund Long-Term Capital Management. Such
transactions, if they are unsuccessful, risk dragging the saviours into a
morass of expanding financial commitments as may be the case with FRB.
A related option is the forced sale or shotgun marriage. It is
unclear how given systemic issues in banking, the blind lending
assistance to the deaf and dumb strengthens the financial system. Given
the ignominious record of many bank mergers, it is puzzling why foisting
a failing institution onto a healthy rival constitutes sound policy.
HSBC, which is purchasing SVB's UK operations, has a poor record of acquisitions
that included Edmond Safra's Republic Bank which caused it much
embarrassment and US sub-prime lender Household International just prior
to the 2008 crisis. The bank's decision to purchase SVB UK for a
nominal £1 ($1.20) was despite a rushed due diligence and admissions that it was unable to fully analyse 30 percent of the target's loan book. It was justified as 'strategic' and the opportunity to win new start-up clients.
On 19 March 2023, Swiss regulators arranged for a reluctant UBS, the country's largest bank, to buy Credit Suisse
after it become clear that an emergency Swiss Franc 50 billion ($54
billion) credit line provided by the Swiss National Bank was unlikely to
arrest the decline. UBS will pay about Swiss Franc 0.76 a share in its
own stock, a total value of around Swiss Franc 3 billion ($3.2 billion).
While triple the earlier proposed price, it is nearly 60 percent lower
than CS’s last closing price of Swiss Franc1.86.
Investors cheered
the purchase as a generational bargain for UBS. This ignores Credit
Suisse's unresolved issues including toxic assets and legacy litigation
exposures. It was oblivious to well-known difficulties in integrating
institutions, particularly different business models, systems,
practices, jurisdictions and cultures. The purchase does not solve Credit Suisse's fundamental business and financial problems which are now UBS’s.
It also leaves Switzerland with the problem of concentrated exposure
to a single large bank, a shift from its hitherto preferred two-bank
model. Analysts seemed to have forgotten that UBS itself had to be
supported by the state in 2008 with taxpayer funds after suffering large
losses to avoid the bank being acquired by foreign buyers.
***
The only other option is some degree of state support.
The UBS acquisition of Credit Suisse requires the Swiss National Bank
to assume certain risks. It will provide a Swiss Franc 100 billion
($108 billion) liquidity line backed by an enigmatically titled
government default guarantee, presumably in addition to the earlier
credit support. The Swiss government is also providing a loss guarantee
on certain assets of up to Swiss Franc 9 billion ($9.7 billion), which
operates after UBS bears the first Swiss Franc 5 billion ($5.4 billion)
of losses.
The state can underwrite bank liabilities including all deposits as
some countries did after 2008. As US Treasury Secretary Yellen reluctantly admitted to Congress,
the extension of FDIC coverage was contingent on US officials and
regulators determining systemic risk as happened with SVB and Signature.
Another alternative is to recapitalise banks with public money as was
done after 2008 or finance the removal of distressed or toxic assets
from bank books.
Socialisation of losses is politically and financially expensive.
Despite protestations to the contrary, the dismal truth is that in a
major financial crisis, lenders to and owners of systemic large banks
will be bailed out to some extent.
European supervisors have been critical of the US decision
to break with its own standard of guaranteeing only the first $250,000
of deposits by invoking a systemic risk exception while excluding SVB as
too small to be required to comply with the higher standards applicable
to larger banks. There now exist voluminous manuals on handling bank
collapses such as imposing losses on owners, bondholders and other
unsecured creditors, including depositors with funds exceeding guarantee
limit, as well as resolution plans designed to minimise the fallout
from failures. Prepared by expensive consultants, they serve the
essential function of satisfying regulatory checklists. Theoretically
sound reforms are not consistently followed in practice. Under fire in
trenches, regulators concentrate on more practical priorities.
The debate about bank regulation misses a central point. Since the
1980s, the economic system has become addicted to borrowing-funded
consumption and investment. Bank credit is central to this process. Some
recommendations propose a drastic reduction in bank leverage from the
current 10-to-1 to a mere 3-to1. The resulting contraction would have
serious implications for economic activity and asset values.
In Annie Hall, Woody Allen cannot have his brother, who
thinks he is a chicken, treated by a psychiatrist because the family
needs the eggs. Banking regulation flounders on the same logic.
As in all crises, commentators have reached for the 150-year-old dictum of Walter Bagehot in Lombard Street that a central bank's job is "to lend in a panic on every kind of current security, or every sort on which money is ordinarily and usually lent."
Central bankers are certainly lending, although advancing funds based
on the face value of securities with much lower market values would not
seem to be what the former editor of The Economist had in mind. It also ignores the final part of the statement that such actions "may not save the bank; but if it do not, nothing will save it."
Banks everywhere remain exposed. US regional banks, especially those
with a high proportion of uninsured deposits, remain under pressure.
European banks,
in Germany, Italy and smaller Euro-zone economies, may be susceptible
because of poor profitability, lack of essential scale, questionable
loan quality and the residual scar tissue from the 2011 debt crisis.
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Emerging market banks' loan books face the test of an economic
slowdown. There are specific sectoral concerns such as the exposure of
Chinese banks to the property sector which has necessitated significant ($460 billion) state support.
Contagion may spread across a hyper-connected financial system from
country to country and from smaller to larger more systematically
important banks. Declining share prices and credit ratings downgrades
combined with a slowdown in inter-bank transactions, as credit risk
managers become increasingly cautious, will transmit stress across
global markets.
For the moment, whether the third banking crisis in two decades
remains contained is a matter of faith and belief. Financial markets
will test policymakers' resolve in the coming days and weeks.
Satyajit Das is a former banker and author of numerous works on derivatives and several general titles: Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006 and 2010), Extreme Money: The Masters of the Universe and the Cult of Risk (2011), A Banquet of Consequences RELOADED (2021) and Fortune’s Fool: Australia’s Choices (2022). His columns have appeared in the Financial Times, Bloomberg,WSJ Marketwatch, The Guardian, The Independent,Nikkei Asia and other publications.
This is part of the web-only series of columns on newindianexpress.com.
