Taking Stock: Where will it end?

Last week Treasury yields fell sharply, the U.S. and European bank stocks continued their collapse, and the First Republic and Credit Suisse failed. Yet things happened that don’t happen in a banking crisis. The NASDAQ index of tech companies rose 6.5%, and the ECB saw fit to raise rates by 50bp, as it continues to prioritise bringing down inflation.

Perhaps it wasn’t so odd: the rally in the NASDAQ can perhaps be explained by the bailout of Silicon Valley Bank (SBV), which was effectively a bailout of tech companies and their investors. The rate hike from the ECB was a message to the markets: forget the talk of central banks going easy on inflation to protect banks, which are so well-capitalised and regulated that you don’t need to worry.

We can expect more efforts to reassure and perhaps signs that investors are reassured, over the coming weeks. But there is plenty of scope for fumbled messaging from central banks and regulators and for fear to grip investors in all risk assets.

If one can predict an end to this, it seems more likely that it will be with failures in leveraged investment vehicles, part of what is dubbed the ‘shadow banking sector’, than in the bankruptcy of a major bank.

A strange bank crisis

This is a strange bank crisis. It is happening in a sector that is generally well capitalised, internationally, and does not appear to be suffering from over-lending into questionable sectors. There has been no ‘the Emperor has no clothes’ moment, when bank lending into a fashionable sector has become unstuck.

The commonalities between the U.S. banks so far affected and with Credit Suisse, are hard to discern, and one suspects non-existent.

Silvergate, SVB, Signature and First Republic fell because of liquidity problems.

They could not cope with higher interest rates that led to losses on their long-dated bond holdings (when priced mark to market). Meanwhile, their deposit base shrank as customers sought better interest rates elsewhere, forcing the banks to crystalise the losses.

Their error was mismatching assets and liabilities. It was a liquidity issue, not one of solvency (no one doubts that the banks’ bond holdings -mostly Treasuries- will redeem eventually at par value).

The same cannot be said of Credit Suisse, the only systemically important bank to fail so far*, with its equity and CHF 17bn of debt wiped out as part of the CHF 3bn acquisition by UBS.

Instead, Credit Suisse had suffered from years of management problems, relating to issues as varied as money laundering, corporate espionage (against its own directors), poor quality lending decisions and -more recently- a record loss reported for 2022 that had prompted a controversial restructuring plan.

Credit Suisse’s end was prompted by a mass withdrawal of deposits by nervous clients that had begun in the fourth quarter of last year and accelerated last week after its largest shareholder declined to inject more capital.

All of which begs the question, if there is little commonality between the U.S. banks and Credit Suisse, does that mean there is no systemic crisis?

Sadly, bank runs don’t ask for logical explanations before they take hold. Fear creates its own rational depositors who withdraw deposits and ask questions later. The 2008/09 financial crisis is too recent in many investors minds to be forgotten, in which the failure of a number of small and medium-sized banks had out-sized repercussions.

Where will it end?

Probably not in the regulated banking sector, thanks to the reforms implemented after the financial crisis that ensure capital adequacy and liquidity. Better oversight of the sub-$100bn U.S banks will likely follow this crisis in return for Fed, FDIC and Treasury indulgence over the coming weeks.

Rather, it is the shadow banking sector that looks most vulnerable. This is a catch-all category that includes money market funds, private equity, hedge funds, real estate…any sector that takes liquid deposits and invests in long-dated, perhaps illiquid, assets. These have grown massively in size relative to bank lending since the last financial crisis and are far less regulated.

The danger is that investors withdraw because of fear, precipitating forced sales of assets and crystalising losses and bringing about the crisis that investors feared.

The best way to ensure confidence in the shadow banking sector is to ensure stability in the regulated banking sector. This allays investor nervousness, as well as ensures banks continue to lend to their investment sector clients. Sunday’s announcement from five major central banks (of the U.S., U.K., Canada, Eurozone and Japan), of unlimited dollar swaps available to their respective banking sectors will do much to settle nerves.

It is, though, likely that losses in parts of the shadow banking sector will mount, which may depress valuations in global real estate, private equity and other alternative asset classes. Money market funds look safe at this time, given the current activism shown by the U.S. authorities.

This week

On Wednesday the Fed is expected to announce a 25bp rate hike. It will also publish a ‘dot chart’, showing the FOMC’s views on interest rates going forward. Many market analysts predict cuts in the autumn, with JP Morgan suggesting potential cuts commencing in September.

The Bank of England was expected to hold rates, but recent stronger-than-expected growth data and a near-term easing of fiscal policy, now has to be balanced against the risk of macroeconomic shocks arising from the banking crisis.

Investors should remain diversified in a diversified portfolio and not try to second-guess the direction or the severity of the current bank crisis.

*Setting aside the Fed, Treasury and FDIC’s decision on Friday afternoon to label SVB a systemically important bank. So, giving the bank the lifelines it needs, but in contradiction to agreements made with European regulators after the GFC, to allow small and mid-sized banks to fail in order to re-install moral hazard.

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