Banking Crisis? Explainer

We entered last week with the initial demise of Silvergate Capital (NYQ:SI) which subsequently led to the second largest US bank failure of all time in the Californian Silicon Valley Bank (SVB).

We now know that SVB’s investments were too heavily weighted towards long-term bond style assets, which is in contrast to the immediate liquidity needs of the majority of their client base who are mainly IT start-ups and tech stocks who have regular short-term liquidity requirements.

With the nervousness around Silvergate, SVB had a run on deposits which saw them have to draw down on these long dated assets, realising significant losses because these assets were purchased when interest rates were at their lowest. FYI when there is an interest rate increase, the value of pre-existing bonds drops, because the new ones have higher rates of interest. This shortfall caused by the selldown saw them approach investors cap in hand for US$2.5billion to sure up the balance sheet. Not a great look for a Bank and unfortunately saw a much larger US$42B run on deposits that ultimately, as we mentioned last week, saw the regulators come in on the Friday to shut it down.

But the dominoes then started to tumble from there… at the time of writing last week’s Momentum Monday report (Sunday US time) we started to receive word that the third largest US Bank failure on record was playing out at the New York based Signature Bank.

The growing nervousness saw the Federal Reserve launched a new “Bank Term Lending Program” which allows a range of banks and other eligible firms to borrow against Treasuries, mortgage back securities and other eligible collateral at face value, That last point is very important because in the past any liquidity support was provided at current values, But it was still not enough to allay the fear in US Banks. More on that in a moment.

By the new week the contagion had spread across the Atlantic with scandal struck Credit Suisse needing to borrow an eye watering $81B from the Swiss Central Bank to ensure immediate liquidity. Part of the fear was attributed to the bank's previous history, and part because Saudi National Bank Chairman Ammar Al Khudairy said that the bank has ruled out further investments in Credit Suisse. The reason why (not often published) was because they wish to avoid regulations that kick in with a stake above 10 percent,

Credit Suisse suffered a wave of selling particularly after the 9th of March when the US Securities and Exchange Commission queried the bank’s annual report, forcing it to delay its publication and panic spread. When the company publishes in their 2022 annual report words to the effect that, it had identified "material weaknesses" in controls over financial reporting and not yet stemmed customer outflows, was it any wonder?

Back to the US and we saw another Bank on the ropes. This time it was the San Francisco based First Republic Bank. However on Thursday US time, an unprecedented show of support for First Republic Bank took place with 11 major Wall Street firms saying they are depositing $30 billion into the Bank as a sign of solidarity and support for the broader sector. Despite this the shares still fell another 33% on Friday.

Apparently the move was orchestrated by the CEO of JP Morgan, along with Treasury Secretary Janet Yellen and Federal Reserve Chair Jerome Powell. Whilst this will do nothing to ease the conspiracy theories around Wall St and Federal Reserve collusion, it does go some way to show that the united tackling of the problem has some semblance of control.

But with so much uncertainty still abounding it was not unusual to see continued selling across the market and regional banks on Friday US time. Given Signature Bank went broke on a Sunday, traders obviously did not want to hold over the weekend.

The $1 million question…

“Is this the start of a new Global Financial Crisis?”

And given the actors, it is a reasonable question to ask.

I just wish to say at this point that I am not privy to the exact funding make up of the World’s Banking system, nor do I possess any particular insight on capital flows or inside information. Therefore these comments are based on what I have read and the veracity of those sources. They could ultimately prove to be wrong, so stay up-to-date with any changing news as this may change this perception.

I don’t believe we are about to enter the next Financial Crisis.

One of my main reasons for this is the quality of asset recorded on balance sheets is far better this time around. In the case of SVB, there was an investment mismatch with the needs of their depositors, not a capital adequacy issue. Cast your mind back to 2008 and back then bank assets included NINJA (no income, no job, no assets) loans which were not worth the paper they were written on when the property sector fell (especially as home loan interest can be tax deductible in the US and there was no recourse on the loans.) Perhaps the asset mix may not have been right. But this time around they are “real” assets. Looking here at Australia, we did not suffer the same problems as others during the GFC due to the prudent way our institutions are managed and the quality of their assets. I therefore don’t suspect there to be a problem now either.

Another reason is the sheer amount of money being bandied around to not only protect the interests of deposit holders, but also the entire system seems excessive, but no doubt designed to hit any fear on the head. For example, the CHF50 Billion (A$81 Billion) loan from the Swiss National Bank to Credit Suisse is obviously designed to hit fear on the head. While this hasn’t worked just yet, once there is a period of quiet, this assurance will act as a support for the institution.

Also regulators (who have better access to data than you or I) don’t seem overly worried. Last week we saw the European Central Bank still raise interest rates by 0.5%. What had been spoken about prior to this decision was that perhaps Central Banks around the world would halt their rate rising cycle in response to this turmoil. Also this hasn’t happened and I have seen recent reports that the US federal reserve will also raise 0.25% when they next meet. For what it is worth, a strong jobs report in Australia will likely see the RBA continue to raise rates as well as its ongoing battle with inflation continues.

With the recent support provided to a wide range of Banks, the balance sheet of the Fed still has capacity. In fact, despite recently rising US$300B in a week, the overall level of US$8.7 trillion is still below peak COVID levels. But as we know, the Fed does have a money printing machine and it is not afraid to use it. Why? Because any currency is only as strong as the economy of the Country it represents. So doing anything (including printing money) to ensure that the US Economy remains the strongest in the world will be something the Federal Reserve is not unafraid to use.

Finally, all bank deposits in the US are effectively guaranteed. The biggest issue with banks going broke is depositors potentially losing all their money with the flow on effects on the economy very significant. However, in the aftermath of SVB and Signature, regulators in the US were quick to reassure deposit holders that not only would they meet the automatic US$250,000 with the FDIC deposit insurance fund, but all deposit amounts would be protected (regardless of whether they were insured or not). No doubt this could be extended to any deposit holders of any subsequent institutions that come under strain and would come as a big relief to regular everyday businesses.

Not unusual

Banks going broke in the US are not particularly rare. In fact there have been 563 since 2001, with many happening before and after the GFC, though as this chart shows, it had been a quiet 2 years recently.

If you are unable to see this chart clearly, click on this link to be taken to the original source.

It is important to note at this stage that a Bank is a financial institution that is licensed to accept checking and savings deposits and make loans. We have far less Banks than the US system.

However the number of de-novo banks” - banks started in the last five years has dropped on account of rising capital requirements and costs, but in my view this is a good thing.

With reports floating around the internet that say that the minimum amount of capital needed to fund a new bank is $20 million, or as I mentally picture it, the equivalent of a house in Point Piper. It starts to become more obvious why there have so many “Bank” failures in the US and why it is the norm.

Conclusion

While such massive events can take time for investors to heal from, in this instance I think they will.

And just like the GFC before it which resulted in better practices in by the Banking sector, I suspect this will be the same this time around.

The fire fencing by regulators should ensure that any collateral damage is kept to a minimum and any disruption should not flow onto companies, or economies off-shore.

Therefore, this will go down as another reminder why risk management for Banks is important and no institute should assume the status quo as accepted. As we have witnessed, these events can escalate much quicker than any protection can be provided. So they will be best to remember that prevention is the best cure.

Of course the fates of Credit Suisse, First Republic and any other institution that gets caught up in all this is unknown. But it is my view that for now all issues are contained and should not change the broader view of the economy.

Further, while I expect there may well be sentiment issues impacting the price of our Banks, I don’t think structurally they are under any risk (just as they weren’t during the past credit crisis.)

All these views may change in the future based on any new information that comes to hand. At Stockopedia we will try our best to stay across any significant issues.

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