Another banking crisis?

Welcome to Finance and Fury. This episode will be about the risk in financial markets over bank runs, and the liquidity fears and contagion risks ramping up in the financial sector – something legitimate or white noise?

Large declines in financials, i.e. banks – Last Friday, the 10^th of March saw large selling on many financial companies – some of this could be due to cooling job figures in the US – however the majority of the sell offs I believe is in response to financial contagion fears – particularly in banks – as two bank failures have occurred in the US – a third was shut down – two part episode – this week looking at Silvergate and how the banking sector works – next week looking at the fallout and collapse of SVB

To start looking at what is going on – some smaller banks are starting to blow up – First Silvergate, now Silicon Valley Bank, Signature Bank also has collapsed –

1. Why are many banks blowing up? Comes down to balance sheets – Assets and liabilities – all of these banks have faced similar issues
   1. Assets for banks are loans and securities that a bank hold – liabilities are deposits
   2. The banks blowing up are having problems on the assets and liabilities sides – mainly in the form of bank runs (being liabilities) and needing to sell assets to meet withdrawals (being assets) but at a loss – so what was liquidity issues turns into solvency ones
   3. To explain this – look at Silvergate – was a large player in the crypto space, providing deposit services for investors and exchanges, allowing for people and exchanges to hold a bank account to interface with trading – filled a gap in the market as not many banks would provide these services due to regulatory requirements
      1. What Silvergate would do is take deposits, then lend these out to traders – so loans collateralised by BTC – Called ‘sendleverage’ loans – around $1.1bn – but for every dollar they held in deposits, they needed further collateral as backing – banks balance sheets need to balance out – assets and liabilities and shareholder equity normally equal one another – looking at CBA – have $1.2tn in Assets, and $1.2tn in liabilities and shareholder equity
      2. Going back to Silvergate – In September 2022 – $11.4bn in securities – bonds, treasury securities, MBS – then $1.4bn in loans and $13.2bn in deposits – most from crypto companies, like exchanges – So had around $13bn in assets and $13bn in liabilities
   4. The problem is that when FTX became insolvent, who Silvergate was the banker for – people who held crypto on exchanges were less likely to do so, so they started withdrawing funds – asking for money back meant that these exchanges had to start withdrawing their deposits from Silvergate – this was essentially a bank ran, not from the loss of faith in Silvergate but from a loss of faith in crypto exchanges and the market at large – 3 months later in December – deposits were down $10bn, to around $3bn – the problem was that to meet these redemptions, they needed to come up with funds to meet the roughly $10bn in withdrawals –
      1. See, banks don’t just sit on your deposits – as it is a liability to them they want to use it to make a profit – in this case Silvergate could buy a debt instrument or lend the funds – earn a profit compared to the deposits on which they weren’t paying interest – works well until everyone wants their money and you have to sell assets – which can be a risk – as what happens if these assets have lost value? This is what happened –
      2. well, they still had over $11bn in bonds and treasuries, and $1.4bn in loans – which are their assets – whilst the deposits are liabilities – so they sold half their bonds and borrowed further funds from a government institution – $4bn to meet the withdrawals and solve their liquidity issues – all in all ended up losing around $1bn
   5. Problem goes a little deeper – The issue appears more systemic though – this is due to the Basel regulations around capital adequacy requirements
      1. the BIS – Central banks of Central banks – provide legislative guidelines for all commercial banks – introduced Bail In laws around 2014 – talked about them about while back in the where to invest and not invest in a crash episode going on 4 year ago
         1. Under the provisions – cash deposits remaining in banks is no longer essential
         2. To avoid bank runs of mass withdrawals, or losses on the lending assets = bank collapse – capital reserves now coming from capital notes, government bonds or other forms of fixed interest – not depositors fund solely – banks now have their reserves for the past decade in the form of debt instruments and not customer deposits

• But each asset has a risk weighted asset score given against it – if a bank holds a treasury – this is considered 0% risk, in Australia a mortgage with a property as collateral is 35%, and BTC and other approved crypto are 100%

1. The problem that Silvergate faces was whilst the were fully capitalised in September last year – the securities being used as collateral lost value, and they needed 100% of the funds

3. Modern Economy – money is created through central banks and lent out to Governments/Banks at the cash rates –
   1. As cash rates got lower – Interest payments on newly issued Gov debt gets lower – if you haven’t noticed, Gov’s globally are in debt – but as every government across the globe is in debt, who to? CBs from the issuance of money – but the issuance of money doesn’t initially go to us – it goes to the financial system – i.e. banks or investment managers –
   2. The lowing of the interest rates helped the CAR system that banks have fixed interest assets values rose – meaning that they could continue to lend more without needing to issue or purchase more tier 1 or 2 capital –
   3. But what happens when interest rates are increased at a massive rate? The opposite happens –
   4. Looking at the unrealised losses over the last 12 months – this is unprecedented – now commercial banks hold either to maturity or available for sale – held to maturity means that the securities are long term security, but available for sale is to cover short term liquidity issues
   5. Going back to the GFC – most commercial banks didn’t need to hold held to maturity assets – so the losses were all on the available for sale securities – which at their peak in 2008 were around $70b – which is a lot – and the held to maturity was around $5bn – so around $75bn losses on the balance sheet
   6. Today – the available for sale is sitting at around $325bn and held to maturity sitting at $350bn – total loss of $675bn – compared to GFC at maximum of $75bn – almost 10x the losses
      1. In 2021 prior to the rake hikes – the securities held were gaining – sitting at a positive $100bn combined due to the decline in the interest rate
      2. The difference in accounting is that held-to-maturity technically can be treated at face value – unless they are sold

• So whilst there is technically a loss of $350bn, this hasn’t been reflected – yet – unless banks need to sell these assets

1. Post GFC – the rules of the game changed – commercial banks were asked to enough High Quality Liquid Assets (HQLA) to meet deposit outflows in a stressed scenario
   1. This effectively means that banks around the world are forced to keep around 10-15% of the asset side of their balance sheet invested in HQLA – could be capital notes in the bank, other reserves or government bonds, or shareholder equity
2. In the US – banks were asked to own a large amount of liquid assets and were told government bonds were the only game in town due to regulation- but also corporate bonds and mortgage-backed securities could qualify
3. Australia was all about Tier 1 capital, or level 1 assets as it is known in the US – come from central bank reserves, or marketable securities – being any asset that is highly liquid and can be sold down quickly to bail in – which in one way could be even worse – did an episode around 3 years ago on “Why do banks seem to have the ability to lend never ending amounts of money?”

So due to interest rate increasing – and the valuation of the capital banks hold is declining – There is a liquidity crunch going

4. Past the point of return for this working – initially most of the money being lent through stimulus and the benefit from declining interest rates were going directly to the financial system – then secondary to you and I through having the ability to borrow more at a lower rate – but this then turns on both us and commercial banks and interest rates increase
   1. The lowing of interest rates started out as a short-term emergency experiment – but now then this short-term emergency experiment became the normal for the better part of a decade of lowering interest rates = more and more then needed to be held by commercial banks to meet the increasing borrowing demand as rates declined
   2. In this case – regulators forced banks to own bonds, capital notes and equity in their own banks – hence banks are now force to adjust to a lot of P&L volatility, as this capital that they lend against is no longer cash, with minimal volatility – many of these assets have lost more than 10% in a 12-month period – obviously banks don’t like that
      1. Remember there are two methods of classifying these bonds – Available-For-Sale (AFS) and Held-To-Maturity (HTM) – whilst both have lost value, only the AFS assets is reflected in the balance sheet but not record as a loss to the banks P&L
      2. Over the past decade – This creates an incentive scheme to park as many bonds in these accounting category – as when banks need liquidity, they can only sell a small portion of HTM bonds now due to the losses on these assets, before they fall outside of the CAR requirements and become non-compliant – so the large extent of HTM losses is worrying – and in the short term additional capital raisings from shareholder equity may be required – this is what SVB tried – more on this next week – and markets didn’t respond well
   3. At this stage – the sector of the financial system that is suffering the most from liquidity & funding are smaller banks – as QT shrinks their reserves – these reserves are use to settle transactions with other banks -they work as the lubricant of the financial system
      1. From the Federal Reserve – reserves as a percentage of assets are declining – jumped in 2020 – small banks 12% and large banks 16% – banks did increase to 16% for small banks and 18% for large banks – but over the last 12 months – banks did decrease to 7% for small banks and 12% for large banks
      2. Reserve repurchases agreements with money market funds – increased from 0% to 25% in the past 12 months – meaning that liquidity injections have been needed to help the system facilitate in small banks
   4. A tougher funding landscape, with plenty of safer and higher-yielding alternatives for depositors This is the real issue, imho.
   5. Another issue in capital markets is that the risk-free asset being government bonds has become risky – more on this next week

In summary –

2. Due to accounting measures, most commercial banks whilst have seen a decline in the reserves, are still okay but the problem has been in relation to small banks – those that are not diversified, either in the crypto or tech start up space – both of which were hit over the last 12 months with increasing interest rates
3. Depositors in this space withdraw their funds, not due to a confidence issue in banks but in the market space they are in – this means banks need to sell assets – which have also seen a decline in value due to interest rates increase – this is the double whammy that is the issue
4. Given that many large commercial banks, particularly in Australia hold assets in loans – with property as collateral – risk of the same events playing out is lower
   1. But the promise to reduce this level of inflation has now introduced massive tail end risks
   2. Problem is liquidity and interest rates and impacts on the CAR of commercial banks
5. This has opened the door to a risk off environment in financial markets -likely to continue up until the point that CBs, particularly the fed reverse course
6. Where things go wrong – collapse in assets – withdrawal or defaults on loans – banks needing to meet – Confidence is the key – if confidence is lost, then it is game over
7. More on all of this in another episode on, looking at silicon valley bank – this failure was risk management failures – as well as looking further into the financial system and contagion fears/risks