Bank failures - After SVB and Credit Suisse, what’s next?

While Silicon Valley Bank (SVB) and Credit Suisse’s failures inescapably evoke images of 2008, we were fairly confident that the latest turmoil wouldn’t turn out to be a Lehman moment.

Lehman was an accident, fostered by a year-long credit crunch and triggered by bad judgement calls from governments and regulators. The lessons were well learned. Central banks have made sure that there’s enough liquidity at all times and are ready to release trillions in the blink of an eye.

Treasuries, governments, and legislatures are also more sensitive to the dangers of economic instability and contagion. This makes them quicker to react, assured that they will not be faced with a widespread populist revolution for saving the financial system. Assurances that liquidity is ample have eased tensions. The use of deposit Fed liquidity facilities remains significant, but at least it has levelled out.

But the US regional banks that failed and Credit Suisse had something in common. They were troubled entities. SVB didn’t have a risk officer and didn’t properly hedge its bond exposure. Credit Suisse was mired in scandal and hadn’t properly transitioned towards a new banking model. If not for years of quantitative easing, their fate may have been sealed a lot sooner.

Cheap lending unavoidably gives rise to moral hazard. Companies with failed business models can easily borrow to keep surviving. Restructuring has risks and could scare shareholders. Why not just shove everything under a cosy liquidity blanket? This also prevents new competitors with healthier and more innovative approaches from taking market share. Incumbents tend to have higher capitalization and easier access to capital. However, when liquidity subsides, the weak are quickly exposed, the market cleanses itself and a cycle of growth and moral hazard begins anew.

The previous cycle was unusually long, lasting for over a decade. Not only that, but the market had become convinced that the absence of inflation and the entrenchment of “secular stagnation”, was a trend of higher savings and lower consumption.

We are at an age of high macroeconomic volatility and profound policy uncertainty. Investors looking at short-term movements in bond and equity markets must not be too quick to think “markets believe” something, or “markets are positioned” for something else.

The recent turmoil in Deutsche Bank’s CDS was down to a few trades. Bullishness, or bearishness, these days is more a matter of reaction than careful strategic thinking. The short-term, “fast” money markets are all over the place. It is the job now of sanguine long-term investors to cut, methodically and for as long as it takes, through the noise.

George Lagarias, Chief Economist