Is the bank ‘crisis’ over?

Welcome to Finance and Fury. In last weeks episode, I stated that I was going to cover the collapse of SVB, but by now this is old news and there have been further developments – so we will still give a quick recap on SVB but the main focus will be on further liquidity issues within the financial system – which could turn into solvency problems – as we will be Looking at Credit Suisse as well – and if all the problems are solved from liquidity injections, or is it just the start of the beginning?

As mentioned in last weeks episode – Higher interest rates are increasing the chance of a default cycle within many industries – increasing interest rates and loss of confidence in just two sectors so far – being smaller tech companies and crypto-centric banks lead to the collapse of three banks

But these instances show the fragility of many smaller banks – as liquidity problems that banks face currently hold all the hidden risks – as the saying goes, you don’t know who is naked in the water until the tide goes out

It should be noted that smaller banks regularly go bust –

1. Signature, Silvergate and SIVB were all US banks with concentrated assets, credit and funding risks – amplified by poor risk management practices
   1. In one way – these sorts of institutions do have a history of collapsing during a time of economic stress – whish is a regularity in the US.
   2. There are over 4,800 banks in the US today – but prior to 2008 – this number was sitting at 8,000 banks – back before the great depression – there were around 26,000 US banks
   3. It is common for smaller banks to collapse each year due to their highly concentrated geographic/industry risks – even after the two major banking collapses in the past hundred years – since the GFC the average has been around 10 smaller banks have collapsed each year – obviously there are spikes in times of economic turmoil – but on average in normal market conditions, one bank will fail each month on average
2. Looking specifically at SIVB – which is now under the control of the Federal Deposit Insurance Corporation (FDIC).

Why did this bank collapse? This bank was not for every day depositors –

1. SVB was unusually concentrated on effectively one industry – Silicon Valley tech industry – providing all of SIVB’s deposit funding – their assets in loans were also in tech.
   1. As the interest rates smashed the tech industry – SVB started losing deposits at a very rapid rate – in 2022, it lost $25 billion in deposits – then on Thursday last week, depositors, being tech companies – all got together on slack and decided to withdraw their money on mass – requesting a withdrawal of deposits of $42 billion on that day alone
   2. This is a problem – but what made it worse is that they didn’t have anyone as a risk manager for the better part of a year – they did not hedge any interest rate risk at all
      1. In risk management – normally you spread the duration risks of your debt instruments – hold some 3m, 6m, 12m, 2y, etc. to spread the impact of interest rate increases – most of their securities on the books, being $212 billion asset were in long duration, i.e. 15 year bonds – there were minimal short-term interest rate – so as interest rates increased, they lost most value on these assets – general rule of thumb – the longer the duration, the more a 1% increase in interest rates will impact the valuation of the fixed interest security
      2. SVB also did not lend most of it $173 billion in deposits – Only 43% was used to fund normal loans – the remaining 57% was invested in financial market securities, carrying huge interest rate risks
   3. There is more to this story – such as the hold-to-maturity assets versus available for sale – but this collapse does come off the back of being 100% dependent on tech companies, many of which are startups – with no diversification on their assets and liabilities
   4. But the biggest risk management failure comes in the form of their allocation of assets – for a fraction of a percentage point increase in yields, their decided to put the a larger, $75.5 billion holding of residential mortgage-backed securities (RMBS) combined with another $15.9 billion of commercial mortgage-backed securities (CMBS) – so over 50% of depositors money – these have most more value since 2021
      24. a smaller $24.6 billion (14.2% of its deposits) allocation to government bonds,
   5. Compare this to a normal commercial banks –
      1. The first priority of any large bank is to hedge the interest rate risk on their asset book (ie, their loans) such that it matches the interest rate profile of their funding (or liability) book (ie, mainly deposits) – this is the most important role in a bank
      2. most banks assets are in long term loans – being 30 year terms – but these loans mature at different time periods – in Australia, with floating interest rates, or short term fixed rates – this helps to minimise the risks – because property is technically the collateral, as whilst there is a mortgage on the property, you do not own your own house
   6. But what about Credit Suisse – which is reaching headlines at the moment as part of the news cycle circling around a banking collapse – if anyone has paid attention, Credit Suisse has been in the toilet for the better part of two decades – First, this is not a commercial bank but an investment bank, that should of failed probably 3 times by now – lost over 90% of its value over the last 10 years
      1. Their Shares dropped a further 24% – but Credit Suisse is beset with problems and the share price is now down more than 50% over the past six weeks – prior to any utterance of a banking crisis
      2. This decline in price dragged down confidence on other EU and US banking shares overnight as fear spreads surrounding the banking system
      3. Things are shaky in confidence – This follows the collapse of Silicon Valley Bank and Signature Bank in the US over the past week.
      4. Why did this bank fall? published its 2022 annual report revealing significant deposit outflows – But also a net revenue decrease of 34% year on year, driven by declines across all of our divisions.
         1. Imagine that any company released a report that their net revenue was down by 1/3^rd – would collapse any company
      5. News only got worse when Saudi National Bank (SNB) confirmed overnight that it would not top up its 9.88% holding in Credit Suisse due to regulatory restrictions preventing it from owning more than 10%
   7. But CS is a systemically important bank – and cannot be allowed to fail – The Swiss central bank has pledged to provide Credit Suisse with extra liquidity if required.
      1. At this stage it isn’t required – Credit Suisse can still met their capital and liquidity requirements – its just that they once again have had poor management and lost money on their investments – remember they are an investment bank, not a commercial bank

But in the event this was a commercial bank – and bank runs were occurring – as a systemically important bank – i.e. not a small or mid-tier bank such as Silvergate or SVB – what would occur?

5. If bank allowed to go bust – and other banks are allowed to go bust – it is likely that a depression will emerge as smaller non-systemically important banks collapse
   1. Think about SVB for a second – many tech start ups and developing companies store that cash at a bank – that bank goes belly up and takes the depositors funds down with them – this leaves many companies short on payroll – they cannot pay employees, they are then out of the job – this flow on effect is what could create significant economic downturn conditions
   2. But what created the situation for SVB in the first place is fears of this happening – so tech companies got together and decided to organise a bank run – which created a self-fulfilling prophecy
6. instead, the statist solution is implemented – to stem fears of further bank runs, where people withdraw their money, creating collapses in banks
   1. In the US – The FDIC has said that it will pay-out 100% of the value of SIVB’s ~US$21 billion of insured deposits on Monday, and make a payment to the US$152 billion of uninsured depositors within a week – it is likely that SIVB will be gobbled-up in part or whole by a much larger bank in the coming days/weeks.
7. This brings us to the next phase – the bank crisis may be over for now – but solvency phase could be getting worse – to explain this – many large banks are nationalised
8. the Fed announced a newBank Term Funding Program (BTFP) – a facility designed to inject liquidity into banks that are facing deposit outflows – hence allowing them to avoid being forced to sell their bond holdings at a loss – the reasons the banks to date have collapsed is due to needing to sell assets at a loss, realising this loss creates a solvency problem – i.e. the loss is larger than they can recover from – so a facility to give out loans to these banks to provide capital to meet withdrawals avoids the sale of any assets at a loss
   1. the limit for this is currently set at $2 trillion – but could be even bigger if required – so it will serve to backstop small bank impaired assets for the foreseeable future
   2. This is a contradictory policy – which means that we now live in a time when i) the Fed is hiking, ii) the Fed is shrinking its balance sheet via QT, and iii) it is also injecting up to $2 trillion in liquidity via the BTFP facility, aka Stealth QE.
   3. Similar to the BoE – engaging in QT whilst having a funding facility for defined benefit pensions to provide liquidity amidst the collapse of long duration UK government bonds
9. You also have other larger banks getting together to be what could best be called a “deposit consortium” – the process is where larger banks get together to purchase banks asserts that are having liquidity issues – this has been used to bail out another bank – such as First Republic Bank – where big banks like JPM and BoA will use billions of newly received deposits from the Fed to purchase troubled banks
   1. In addition – any deposit that JPM received from regional/small bank XYZ, will be promptly recycled as a new deposit back into regional/small bank XYZ to keep it 
   2. That last word is critical, because between the asset and liability backstop, the liquidityphase of the banking crisis is now over. But what about the solvency phase?
10. As we discussed last week – Small Banks Are In Trouble – small banks not only have net unrealized losses on their Held to Maturity portfolios, but also on their exposure to commercial real estate in general, and office buildings in particular.
11. The risk will come from the asset side and liability side of balance sheets – as we have seen – the risk to liabilities is quick withdrawals of deposits – but on the asset side – this as also has been seen can be in the form of losses on bonds/fixed interest assets – but many commercial banks hold property, or MBS – which may also be on shaky ground with increasing interest rates
    1. Some of the most vulnerable property assets held by banks are residential real estate, malls, and hotels – If you have money in large commercial banks – not much of a concern – but depositors, or investors in small banks with an over allocation to exposure to commercial real estate (and offices in particular) could suffer losses – For now, investors are taking a shot gun approach, dumping the regional and small banks en masse
       1. Evidence of this is from the fact that property ETFs are plunging to the lowest level in years
    2. Whilst large banks still are very well capitalized, small banks – the core constituents of the property index in the US – are in trouble
    3. small banks – are now sitting with reserves pretty much at their lowest comfort level, There is not much of a cash-to-asset cushion left for small banks as a whole, so a funding crisis can easily get rolling if large depositors decide too many loans in commercial real estate and other areas are about to go bad. The Fed will make funds available to keep these banks afloat, but they don’t meet the threshold as systemically important banks – so they have had less oversight, but also the Fed will not try to save these banks at any cost – they will probably announce further liquidity injections into the system to avoid confidence loss –
12. Ahead of any banking problem rooted in bad loans turning into a funding problem, banks are going to pull back on lending at an even faster pace.
    1. This leads to a credit crunch – less money being lent to business or property leads to less growth in these sectors – leading to less profits from real estate companies, leading to more loans turning bad – leading to greater defaults of small banks

In summary – the risks to banks at the moment are the same as always – but the one major risk to the financial system comes from smaller US banks at the moment – if their loans to commercial real estate turn bad – or depositors withdraw money on mass – creating a bank run

1. Throw in a cascade of bad debt in exposure to office real estate and you could see a repeat of the 2009 banking crisis for the small banks… if only in the beginning, because once the small banks go down, the big banks that have contagion risk would be sold off due to fears of further defaults
2. The bottom line – the acute phase of the bank crisis may now be over thanks to the Fed’s Stealth QE and JPMorgan’s recycling of newly acquired regional bank deposits back into the same regional banks that saw bank runs in the past week
3. but now the slow burning – solvency – phase is starting to accelerate and until the Fed cuts rates, expect a mood, sentiment and price rollercoaster as investor focus increasingly turns to what is the next big threat, not to mention Next Big Short, facing the financial sector.

Large, diversified banks have the opposite problem right now: as investors exit riskier asset-classes, like listed equities, commercial/residential property, venture capital, private equity, and high yield debt, and start chasing attractive, 5-6% interest rates on cash, the bigger bank deposit inflows have surged while their balance-sheet growth is slowing