Yves here. Satyajit Das has taken upon himself to provide a deep dive into what happened in the bank panic and how financiers got themselves in such a mess.
To add to Das’s piece: he points out in the era of super duper low rates, banks bought a lot of government and agency securities rather than making loans. This skew was extreme due to a weak “recovery’ after the crisis, widely described as secular stagnation. Some analyses suggested that financialization was a cause, that high levels of financial activity are correlated with lower growth. But as we pointed out in 2005 (no typo), companies have been net saving. That means not just under-investing but liquidating due to an extreme short-term profit focus making many economically attractive investment project look bad due to their near-term impact on the income statement. Another negative has been insanely high profit levels, now nearly 12% of GDP. That results in CEOs and investors will invest only in super-attractive-looking projects….when they can’t even judge future results with much accuracy.
By Satyajit Das, 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)
Asked about the impact of the French Revolution, Chinese Premier Zhou Enlai in 1972 allegedly stated: “Too early to say”. In fact, mistranslation or misunderstanding meant that Zhou was referring not to 1789 but the 1968 Paris student uprising. Fashionable comparisons between the financial crisis of 2008 and current volatility require a similar response. It requires a longer view of things than that in vogue in a world of tweets and clickbait. Part 1 of this two part piece- Bonfire of the Banks– examines the problems of the global banking sector. Part 2 – The Usual Suspects – will look at possible areas of contagion elsewhere within the financial system.
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Financial crashes like revolutions, to borrow from Leon Trotsky, 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. To update Senator Everett Dirksen’s mis-attributed but oft repeated line: a trillion here, a trillion there, and pretty soon you’re talking real money.
The key areas of concern are, as usual, the banks and various arcane lacunae of the financial system.
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Commentators have resorted to lazy literary references – Hemingway (going bankrupt two ways, gradually, then suddenly) and Tolstoy (happy families resemble one another but each unhappy family is unhappy in its own way). The position is more nuanced.
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 SVB and two-thirds of FRB deposits were uninsured, creating predisposition to a liquidity run in periods of financial uncertainty. FRB also had a high 111 percent loan-to-deposit ratio meaning it has loaned out more than its customer deposits requiring it to fund the shortfall in wholesale markets.
Around 90 percent of failed Signature Bank’s deposits were uninsured, much of it from middle market businesses, such as law firms, accounting practices, healthcare companies, manufacturing companies and real estate management firms. It also worked with crypto clients.
The crisis is not exclusively American. Credit Suisse (“CS”) has been, to date, the highest profile European institution affected. The venerable Swiss bank – which critics dubbed ‘Debit Suisse’- has a troubled historyof 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 high profile management snafus – corporate espionage, CEO turnover and repeated unsuccessful restructurings.
In February 2023, CS 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. CS 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 CS 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.
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Financial intermediation entails risk -either credit or market- and mismatches. With higher capital charges on some forms of lending, banks took on interest rate and liquidity risk.
Banks globally increased investment in high quality securities – primarily government and agency backed mortgage backed securities (“MBS”). The reasons are straightforward:
- An excess of customer deposits relative to loan demand in an environment of abundant liquidity driven by rapid growth in money supply and significant issuance of debt.
- 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 later 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 FDIC 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.
The reasons are as follows:
- They assume that these securities will be held to maturity and therefore redeem at face value. In part, this reflects the fact that banks are required to hold a portion of their portfolio continuously in high quality securities to meet bank liquidity regulations.
- The yield premium available on term securities relative to short-term funding costs increases earnings. Low interest rates and central bank manipulation of the term structure of interest rates (yield curve control) has forced investment in longer maturities increasing the interest rate risk.
- The ‘hide-till-maturity’ accounting treatment which does not require hold to maturity investments to be revalued (the actual market value of holdings is buried in the notes to financial statements which only insomniacs read) means losses do not affect current earnings.
Additional complexities inform some investment portfolios.
Japanese investors have large holdings of domestic and foreign long-maturity bonds. Norinchukin Bank holds around $293 billion of collateralised-loan obligations (“CLOs”), effectively securitised corporate borrowings. Japan Post Bank, which is around one-third owned by the Japanese government, has increased investments in foreign securities from negligible levels in 2007 to 35 percent of its total holdings. Long-term foreign-bond holdings by ‘other [Japanese] financial corporations’ (insurance companies, mutual and pension funds) totals $1.5 trillion as at June 2022.
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 which 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 CS highlights, strong capital and liquidity ratios count for littlewhen depositors take flight. Just as the genius of Keyzer Soze (which in Turkish means someone who talks too much) is to pass himself off as Verbal Kint in The Usual Suspects, banking’s greatest trick is convincing depositors that liquidity risk does not exist. While deposit withdrawals are possible most of the time, that may not always be the case.
Banks now face falling customer deposits as monetary stimulus is withdrawn, the build-up of savings during the pandemic are 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.
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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 are incorporated. Higher rates will affect interest sensitive sectors of the economy.
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. Since 2018, in the US, monthly mortgage repayments on a new median-price house with a 20 percent deposit has risen by nearly 90 percent (from $1,259 to $2,360) because of higher property prices and interest rates. Similar increases are evident globally.
Risks in commercial real estate are increasing. Office occupancy is affected by the post-pandemic ‘work-from-home’ trend. Demand for retail and commercial properties is declining because of the shift to online shopping and lower spending (due to reduced disposable income) and. Overinvestment in industrial and logistics space, which overestimated the need for fulfillment of online transactions and emphasis on re-shoring, is another factor.
The construction sector globally shows sign of slowing. 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 the $1.5 trillion high-yield bond market. There were similar rises in Europe and elsewhere.
There are several complicating factors:
- Credit standards have weakened as borrowers took advantage of lenders with surplus loanable funds driving higher levels of borrowing and negligible margins of safety.
- The proliferation of ‘covenant lite’ loans diluted creditor protection. This reduces the ability of banks and investors to step in early to mitigate distress and increases losses in bankruptcy.
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 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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On 12 March 2023, US Treasury Secretary Janet Yellen stated: “I have full confidence in banking regulators to take appropriate actions in response and noted that the banking system remains resilient and regulators have effective tools to address this type of event.” The statement was reminiscent of the statement of then US Treasury Secretary Henry Paulson almost exactly 15 years ago on 16 March 2008: “We’ve got strong financial institutions…Our markets are the envy of the world. They’re resilient, they’re…innovative, they’re flexible. I think we move very quickly to address situations in this country, and, as I said, our financial institutions are strong.”
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 than then why evoke the ‘systemic risk exemption’ to guarantee all depositors of failed banks? If there is liquidity to meet withdrawals then there 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.
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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. The largest 4 and 10 banks control around 40 percent and 50 percent of total industry assets respectively. The vast majority are smaller institutions – 99 regional banks (between $10 and $100 billion in assets) control $2.7 trillion in assets; 3,500 community banks (less than $10 billion in assets) collectively have $2.8 trillion in assets.
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 4 (now 3) major institutions and a large number of cantonal, regional and savings banks.
Resourcing and costs mean that proper rigorous management of all banks is nearly impossible. Even if they were adequately staffed and equipped, 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. While the US has the FDIC, there is currently no uniform Euro-area wide system of deposit insurance. A 2015 proposal is due to be implemented in 2024 despite understandable German resistance to de facto underwriting the system through risk pooling arrangements. Currently, the major backstop is a patchwork system, founded on national deposit guarantee schemes of up to €100 000 ($106,000) of uncertain quality due to variable ability of individual countries to meet their obligations.
Deposit insurance 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. Should the coverage extend to billionaire investor Peter Thiel who had $50 million in SVB which he believed would not fail even after his fund warned portfolio companies that the bank was at risk?
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. If the government wishes to safeguard all depositors, then a preferable if unpalatable option may be to bring the banking system under state ownership as a provider of essential utility-like services.
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.
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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. Cynics may argue that this has more to do with avoiding increased regulation and individuals securing their legacy as modern successors to JP Morgan himself.
Moreover, such transaction, 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 which 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 CS 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. Without any hint of irony, CS chairman Colm Kelleher, whose St. Patrick’s day celebrations and plans to watch Ireland play England in a historic attempt at a clean sweep or ‘Grand Slam’ in the Six Nations Rugby Championship was interrupted by events, called it “a historic day…[which] we hoped would not come”.
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 CS’s unresolved issues include 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 mergerpurchase does not solve CS’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.
After 2008, large investments by cashed-up sovereign wealth funds and state influenced entities helped re-capitalise stricken Western banks. It is unlikely that option will be available now especially after the decimation of the Saudi National Bank’s Swiss Franc 4 billion ($4.3 billion) investment in CS made only in late 2022. Other Middle-Eastern investors also lost heavily. They were unimpressed by the opacity of the ‘rescue’ process which, they felt, ignored their interests.
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The only other option is some degree of state support.
The UBS acquisition of CS 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 check-lists. Theoretically sound reforms are in practice not consistently followed. 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 implication 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 apocryphal 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 on 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. Emerging market banks loan books face the test of an economic slowdown. There are specific sectoral concerns such as that 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 the 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.
© 2023 Satyajit Das All Rights Reserved
A condensed version is published in the New Indian Express.