Surely a few bad apples can't cause a global banking crisis?
“All happy families are alike; each unhappy family is unhappy in its own way.” So said Tolstoy in ‘Anna Karenina’. While this may be true of households, it often feels the opposite is true in financial crises, especially those involving banks, where all too often a familiar litany of questionable practices and even outright fraud emerges.
Banking was back on the front pages of the newspapers a few weeks ago with the closure of Silicon Valley Bank (SVB). Almost immediately the focus was on bad practice; the lack of interest-rate hedging, poor asset allocation, questionable share-sales in the C-suite, a rising level of loans to employees and so on.
The problem though is that while much detailed analysis of SVB has an ad hominem feel, the banking authorities ended up doing a bail-out of the bank rather than a bail-in (ie depositors were made whole even as the equity and other debt-holders were wiped out). Not only did this ride rough-shod over nearly fifteen years of regulatory planning, angering the regulatory authorities in the UK and Europe, but the debate it raised over the status of deposits has arguably caused a wider confidence issue in the global banking sector1. If circumstances demand that regulators ignore their own process, why should investors trust the banking system at large?
Back in the summer of 2007, the failure of the UK’s Northern Rock was a key moment in the burgeoning global financial crisis. The credit crunch had already started, but it was Britain’s first bank run since 1878 which put banking front and centre in the public eye. The Rock had been a stock-broker darling for a number of years due to its rapid growth and high earnings, but it turned out that a complete reliance on the wholesale funding markets, poor risk management and questionable business practices (remember the 125% loan-to-value mortgage?) made it highly vulnerable in an economic downturn.
Borrowing short (and cheap) in the wholesale funding markets and then lending longer (and dearer) to homebuyers worked a treat until the yield curve inverted and short-dated rates ended up higher than longer-dated ones. Because of its extreme business model, Northern Rock went bust almost right away. While SVB’s problem was a fall in price of its long-dated assets rather than trouble in the funding market, its business model was equally extreme in its own way. Poor interest-rate risk management meant both banks suffered a run on deposits ending up in insolvency.
No bank that suffers a bank run can be said to have been run well. Quite the opposite. But the finger pointing and jeering from the gallery (bankers are greedy and short-termist etc) often overlooks more general structural and cyclical issues which need further examination and which often have wider implications, particularly on the eve of a recession.
SVB’s insolvency has triggered a deposit run in other smaller, regional banks in the US. Some likely have similar issues with respect to unrealised losses on the balance sheet. Some probably don’t hedge their interest rate risk very well. Yet most are totally different in character to SVB in that rather than lending to venture capital funds they are locally-focused, particularly in America’s agricultural heartland where small banks cater to local farmers at an intimate level. Small probably means not diversified, but isn’t small good in the context of too big to fail?
JP Morgan estimates that up to $1 trillion of deposits may have left smaller banks in the US to find their way into the big money-centre banks as well as into money-market funds or T-Bills. It is unclear at this stage whether this is just a ‘bank run’ from a sudden lack of confidence due to banks carrying unrealised losses or an acceleration of a more rational reallocation of savings from stingy deposit accounts to mutual funds offering more generous rates of interest. Either way, higher interest rates from the Fed are the obvious cause of both the unrealised bank losses and the new-found investor choice in terms of places to park their savings. Clearly Treasury Secretary Yellen’s flip-flopping over the extent of deposit guarantees is not adding to market confidence at this stage, but the proximate cause of the problem is rapid Fed rate hikes.
At the start of the global financial crisis, Europeans were quite smug as the UK and US banking systems were struck by subprime contagion but the ensuing Eurozone crisis soon wiped the grins off euro-faces. It turned out that prior to 2008, many smaller banks across Europe had made poor lending decisions especially in the real-estate sector, and the consequences verged on the existential for Europe and the euro.
Spain wasn’t quite the epicentre of the Eurozone crisis but definitely played a best supporting actor role. The regional Spanish banks (Cajas) had hugely ramped up their lending in the property sector, and many of these loans turned sour in the crisis. Like the regional banks in the US, the cajas had a long and noble history as community banks, and the sector’s decimation had a wider social and cultural impact. There was eventually a bailout and a restructuring, but one done in a particularly ham-fisted way which saw a public IPO of Bankia when it was still basically insolvent due to inadequate loan-loss recognition. Not the regulator’s finest hour.
There was a lot of chauvinistic nonsense in the press at the time about lazy Spaniards comparing unfavourably with hard-working Germans as though the crisis was purely a question of moral turpitude in southern Europe. Nothing could have been further from the truth.
With the adoption of the Euro, interest rates in Spain fell sharply, making borrowing easier and more attractive. This was clearly not Spain’s fault in any meaningful way. Likewise, German government policy suppressing domestic wages forced the country to run a current-account surplus, driving excess savings from Germany to Spain where they fuelled a debt-driven property bubble. As Michael Pettis has so clearly demonstrated, this can hardly be considered the fault of small regional banks in Spain2.
In the same way, with fifteen-odd years of very low interest rates, how much can banks and businesses can’t all just be blamed for acting in a manner which now looks a bit dumb given the rapid and largely un-telegraphed rise in central bank policy rates of the last twelve months. With respect to America’s regional and community banks, how culpable are they in this process if they are basically just doing what they’ve always done? The ad hominem approach to criticising banks is clearly not the most productive avenue of analysis.
In a supremely-financialised world, one ought not to be surprised that banking crises, especially those that inhibit bank lending, mark the start of recessions. One also ought not to be surprised that the flakiest and the less sophisticated banks get into trouble first. But is this current issue just one of a few bad apples amidst what is likely a much safer and better-capitalised banking system than that of the 2007-9 era?
Answering this question is critical, especially for Europe, where following SVB’s bankruptcy Credit Suisse has had a shotgun marriage to UBS and where the market’s focus has shifted to other lenders, most notably Deutsche Bank. With all due respect to small banks in the mid-west, it’s problems at the big dogs which can really destabilise markets. Is any of this fear really justified?
The manner of the official crisis response is key. The tendency for governments, central banks and regulators to react piece-meal and unilaterally to crises often means that the market does the same, moving from one target to the next as the interventions raise more questions than they answer. The eventual shift from piece-meal to system-wide programmes (particularly liquidity programmes from central banks and potentially this time around in terms of deposit guarantees) then often makes the whole thing look systematic. If one country doesn’t follow suit, then all the fury is focused there - an interesting analogy is the panic into lockdown as Covid hit in 2020, with only Sweden amongst the developed nations opting for the ‘creative destruction’ approach.
Making SVB depositors whole and then suggesting other potential cases will be dealt with on a case-by-case basis is the very definition of inconsistency. Yellen et al need to get their story straight and soon. Was the bailout of SVB the ‘cause’ of Credit Suisse’s deposit flight and subsequent demise? While the timing looks suspect, it is hard to argue for a direct link, especially in the context of the refusal of the bank’s Saudi shareholders to offer the bank any more equity capital. More likely, these events merely acted as catalysts to the bank’s demise amidst a long litany of misdeeds (Mozambique, Greensill and Archegos standing out amongst them). Contagion is clearly a grey area.
In yet another example of intervention causing unexpected consequences, the Swiss regulator FINMA’s decision to wipe out certain Credit Suisse bond holders (the contingent convertible class or CoCo’s) while retaining some equity value looks like a perversion of the usual order of preference for creditors. Litigation from angry creditors aside, this action has repriced the rest of the European CoCo sector dramatically. The yield on Deutsche Bank CoCo’s has risen from around 10% to over 23% in the past week following the Credit Suisse bailout. Somewhat inadvertently, Deutsche Bank finds itself in the firing line.
Yet Deutsche Bank has a long and ignoble history of market abuse and regulatory fines. Based on its own history and what happened to Credit Suisse, no one would be that surprised if it ended up being nationalised or broken up, but what is certain is that the German government and regulator (Bafin) will not order a bail-in at this stage, nor let it go bust Lehman-style. That said, Deutsche Bank has a 13.4% core Tier-1 equity position and is thus well capitalised. It was profitable last year, with a 2022 return-on-equity of 8.4%. Why should it go to the wall now, and if it does, who’s really to blame?
The point here is to think of the crisis as an event in itself not just a series of events affecting one cowboy outfit after another. The idea of contagion makes the analysis harder, involving as it does the idea of institutions being caught up in something not of their own making. The whole global economy has spent 15-odd years with very low interest rates and during that time a record amount of debt has built up, much of it spent on questionable investments and projects. While low rates helped solve the immediate issues of the last financial crisis, they have sown the seeds of the next one.
One thing the SVB bankruptcy has done is focus investors minds on the effect of sharply-rising interest rates elsewhere in the financial economy. As the value of US Treasuries has tumbled, so has that of commercial real estate. Private markets (venture capital and private equity) are more opaque in their valuations, and suspicion is rising that losses must be taken there.
Rather than just being an issue of deposit flight caused by interest-rate risk, perhaps the last few weeks have seen the start of genuine market concerns about the credit quality in bank assets and other leveraged parts of the economy. Bond issuance has understandably all but ground to a halt. Given the build up of debt at a global level in the past fifteen years or so and how this links banking crises to economic slowdowns, the right question might not be when is the recession coming, but rather why has one taken so long to arrive.
Laura Noonan, European regulators criticise US ‘incompetence’ over Silicon Valley Bank collapse, Financial Times, 16/03/2023.
Michael Pettis, The Great Rebalancing, Princeton University Press, 2013, p128-9.