Banking: crisis, what crisis?

The swift fall of the banks based in Silicon Valley that serve the emerging tech industry was disturbing. As was the quick collapse of one of Europe’s largest banks, Credit Suisse, and its hasty takeover by its rival, UBS. Shareholders sold stock in Credit Suisse and in other banks in Europe that should’ve been regarded as strong and ‘too big to fail’.

So, are we due for another financial crisis?

A repeat of the scale of 2008 is unlikely. Yes, there was some contagion as depositors in Europe got jittery about the financial stability of even the larger banks. Yes, FTX collapsed dramatically only a few weeks beforehand, though that was through fraud. Yes, two lenders to the crypto industry collapsed, though these were highly niche. And yes, bank shares are down, though they are rallying now.

But this time, there are no subprime-mortgage-backed securities disrupting the system, and several bank failures are due to poor risk management. Overall, there has been less reckless lending than in 2008. Quite the opposite: lenders have generally been more cautious than in the past, mainly thanks to stricter regulations. Banks are more resilient now: better capitalised, with higher liquidity ratios, earnings and asset quality, especially in Europe. Far fewer banks have needed to be rescued, and there has been more private sector involvement. JP Morgan has led other banks in supporting First Republic, and First Citizens Bank has taken over much of Silicon Valley Bank, with HSBC picking up the UK arm.

The Federal Reserve has promised to back-stop other banks in America, for example by lending against face value of securities. Credit Suisse was atypical as it had ‘material weaknesses’ in its reporting: five quarters of consecutive losses; profitability had dropped recently, and it had anti-money laundering issues. Perhaps investors over-reacted by selling stock but then it had also suffered a 70% drop in value in the last three years[i].

Watching brief

There’s no need for the financial services sector and its customers to panic, but we do need to watch for indicators that could spook investor confidence. Banks should now be scrutinising their asset portfolio and its maturity mix, and performing liquidity stress tests (e.g. liquidity coverage ratio (LCR). What are the potential losses, for example, if bond investments were marked to market and they needed to offload them quickly?

One of the almost intractable dilemmas right now for central banks is to both control inflation and ensure financial stability. Raising interest rates in the hope of keeping inflation low results in banks’ government bond assets losing their value, at least on paper. This can dent depositors’ confidence and result in a run on the bank, aided and abetted by today’s rapid technology. Could this have been avoided, though, if banks were applying the interest rates increase to their deposits?

Tightening credit will also mean less needed investment in business, which will reduce growth potential. Economic expansion is already being curtailed by higher energy and fuel costs, logistics snarl-ups, lack of skilled workforces, growing inequality and climate change consequences – on top of high inflation. Luckily, it looks like this last indicator is slowing down in several countries.

Through a legal nicety, the investors in additional tier one (AT1) bonds in Credit Suisse have found their debt to be junior to shares and therefore worthless[ii]. To make it more galling for the (mostly) asset-manager investors in the debt, the stocks now have a decent chance of growing under UBS management. Although this cannot happen in the rest of Europe or America, it has rocked the conventional view, especially in Switzerland, one of the world’s largest financial buy-side hubs.

Another issue is that in the US, depositors with up to $250,000 are insured by the government if their bank collapses. This is a small sum to most commercial and industrial firms, including start-ups. There have been confusing messages from the Fed and the Treasury as to how much more or which depositors, if any, would be insured in future.

Larger implications

Although big-league New York banks get the media spotlight, small and medium-sized lenders are just as important for America’s economy and society. For example, those with less than $250 billion in assets, represent 50% of the country’s monies, 50% of business lending, and four-fifths of commercial real estate loans[iii].

Yet to prop up banks whatever the cost, by the government or the private sector, through guaranteeing the value of their securities, providing cheap loans and underwriting risk, cannot be the answer in the long run. A big risk in creating ‘zombie’ banks, detached from market reality, is that their lending is poor (less rigorous due diligence, for example). And you’re just putting off inevitable disaster, which will be more costly in the end to the system and taxpayers.

The rescuing of these banks hasn’t cost the taxpayer yet; UBS has received taxpayer-backed loans. There has been no nationalisation this time either. We are, though, likely see tighter banking regulations: the G20 countries’ Financial Stability Board will likely ask banks to take less risk.

Will the economy and society be better protected in the future? The UBS takeover has resulted in a gargantuan bank whose combined assets are worth two years of Switzerland’s total GDP[iv]. Greater banking consolidation is not ideal for competition and therefore not in the depositors’ and borrowers’ interests. Less credit will be available; less risk will be taken, resulting in less innovation, less corporate finance, fewer start-ups, less stimulus for the economy.

One final thought: the last crisis is not the next one. We cannot assume that the same economic and financial conditions will prevail for the next decade. After all, current stress tests, developed since the last crisis, would not have taken account of inflation and rapid interest rate rises….

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[i] https://www.economist.com/finance-and-economics/2023/03/19/a-momentous-but-unhappy-union-ubs-saves-credit-suisse

[ii] https://www.bloomberg.com/opinion/articles/2023-03-21/credit-suisse-at1-who-is-stuck-with-the-worthless-bonds-is-a-puzzle?leadSource=uverify%20wall

[iii] https://www.economist.com/finance-and-economics/2023/03/23/how-much-longer-will-americas-regional-banks-hold-up

[iv] https://www.economist.com/finance-and-economics/2023/03/19/a-momentous-but-unhappy-union-ubs-saves-credit-suisse

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