When I was asked about Silicon Valley Bank (SVB) this time last week, I made the point that it's an idiosyncratic risk. Today, when I'm asked about what has happened at Credit Suisse (CS), I make the point that it is an idiosyncratic risk.
Perhaps I sound like a broken record in March, so a second look at the banking sector could be relevant. After all, the sum of idiosyncratic risks can trigger something bigger.
Regulators have learnt important lessons from the GFC
We all like to make a long list of lessons learnt by the banks from the Global Financial Crisis (GFC). But I think this is also (more?) relevant for the regulators. The strong actions from the Federal Reserve System (Fed), the Swiss Financial Market Supervisory Authority (FINMA) but also the European Central Bank and the Bank of England are a demonstration of this learning curve, to my opinion.
In a purely capitalistic world, you would prefer to see a failing company default and unwind according to the order of payment priority (or seniority). But a bank isn't a company like any other. There is a multiplier effect in its activities. It will collect deposits and reallocate them to multiple – more or less liquid – assets. After all, we are happy to find a lender to fund our mortgage, aren’t we?
Nevertheless, this business model assumes that the funding is relatively sticky. As a result, the bank can properly function with the business-as-usual inflows and – more importantly – outflows. A bank run simply represents the idea of a lack of confidence in the bank and leads to dysfunction on that side of the bank’s balance sheet. Additionally, alternative funding for a bank is quite costly in a rising-rate environment which adds pressure to the bank in times of stress.
Managing contagion risk
On that side of the balance sheet, the fast liquidity support shown seemed to me like the right answer as the central bank wants to fix the issue for Bank A, while avoiding the spread to Bank B, C and D. To stop the contagion risk, central banks must come with a one-size-fits-for-all solution for SVB. The toolkit and the message that came with it should be sufficient to bring rational people into the safety zone. It is taking us one step closer to “QE Infinity” of course, but it is necessary to impact non-rational behaviour.
In the context of CS, it was clear that something had to happen to enable the bank to reach the weekend in one piece, as some kind of capital raise and/or rescue was mostly baked in.
Regarding the asset side of the banks, a lot of things have been written on the risk taken by SVB over the last week. A lot has been written on CS risk over the last decade.
These cases are very different in nature but when combined they drove a push towards a ‘contagion’ mindset. First, the merger of CS (and not its resolution) on the back of a fast-track new piece of law to sacrifice AT1s is a hard one to swallow for the credit market. It has created a mini contagion to the $200Bn AT1 asset class. Investors will ask: is my AT1 debt worth anything if it can become subordinated to equity? I see this as a storm in a $200bn teacup. It is non-negligible but specific to this asset class. Some people have already argued that the AT1 market will be closed for a long period of time on the back of this event. I am more optimistic, and I think that the market will move on once the reasons of the Swiss authorities’ actions are well-documented and differentiated from the rest. Indeed, the latter has already started.
Regarding SVB, the damage is deeper. Fundamentally, it shows the flaw in the business model of a bank when one side of the balance sheet spirals out of control. The Fed will have to do further work to get this sorted once and for all potentially. I would not be surprised if they also try and tighten the overnight reverse repurchase facility (ON RRP) to reduce the flows towards private sector eligible money market funds, the main recipients of US bank deposits. With tighter eligibility criteria and more regulation, lower counterparty limits and lower offer rates, it could reduce the attractiveness of this alternative. However, this is easier to say than to implement I presume and is certainly not the short-term fix that the Fed may identify.
How resilient is the banking sector?
Overall, CS is a great test case to prove the resilience of the banking sector while the spectre of the GFC continues to haunt the investor community. This resilience has been facilitated by the regulators, as explained above, and by the banks (with capital strengthening over the last decade). On the other side of the pond, the situation in the US has arisen because of the cracks in the system that must begin to appear on the back of such a fast rate hiking cycle.
I have the conviction that the sum of the individual parts has already triggered a new credit cycle. The banks will significantly tighten lending criteria and the consequence of the new rate level will gradually put pressure on borrowers. This outcome is a well-expected crack in the system and a slower burn. Is that it? March is teaching us to be ready for the less obvious cracks. Let’s simply hope that the various symptoms popping up here and there will not push too much else off track before the actual and final pain hits (with a central scenario of stagflation or a recession and default cycle).
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