There was a widespread belief in the wake of the 2007-2009 Global Financial Crisis that weaknesses in the world’s banking system had been addressed and balance sheets were pretty much bullet-proof. Well… last week’s fiasco has gone a long way towards dispelling that belief. Vulnerabilities in banks can still cause turmoil in the marketplace, panicking investors into rushing out and selling their risk assets for the perceived safety of government bonds, gold bullion… and even bitcoin.
Silicon Valley Bank was the 16th largest in the US. Earlier this month, investors and depositors tried to pull US$42 billion in one day creating one of the biggest US bank runs in more than a decade. Founded in 1983, primarily in a bid to meet the needs of the region's start-up companies, its main strategy was to collect deposits from businesses financed through venture capital. It then expanded into banking and financing venture capitalists, adding services to allow it to keep clients as they matured beyond their start-up phase.
SVB’s collapse sparked concerns that other banks – such as Signature Bank and First Republic – could also be in trouble.
Indeed, the regulator announced last Sunday that Signature was being taken over to protect its depositors and the stability of the US financial system more widely. JPMorgan then stepped in with support for First Republic following an 80% fall in the value of its shares.
Although SVB’s collapse happened suddenly at the end of a frantic 48 hours, the seeds of its demise were sown several years ago. Like many banks, SVB ploughed billions of dollars into US Treasury government bonds during the era of near-zero interest rates.
What seemed like a sensible strategy at the time came undone as the Federal Reserve Bank aggressively hiked interest rates up to tame inflation. When interest rates rise, bond prices fall. As yields soared, the value of SVB’s bond portfolio was eroded.
The SVB portfolio was yielding an average of around 1.79%. The benchmark 10-year Treasury bond yield, meanwhile, was hovering at around 3.90%. Something had to give.
The Fed's aggressive rate hiking programme sent borrowing costs higher, meaning that tech start-ups had to channel more money into repaying their debt. At the same time, they were struggling to raise new venture capital funding. This forced companies to draw down on their deposits held by SVB to fund their operations.
When customers, traders and investors hit the panic button – as they so readily do nowadays – it just creates further problems in the financial system. SVB’s stock plummeted by around 60%, dragging down bank shares and the overall sector – unfortunate for the more robust banks. Fortunately, the US Treasury Department, the Federal Reserve Bank and the Federal Deposit Insurance Corporation all committed to ensuring that depositors with accounts at SVB and Signature Bank would have access to their funds, going some way towards calming nerves. But there was more to come…
In the UK, HSBC stepped in to purchase SVB UK for £1, securing the deposits of thousands of British tech companies. The decision to do this was based on several reasons. It was important to steady the UK economy, and the purchase was an opportunity for HSBC to associate itself with more fast-growing sectors. It was also a cheap way for it to boost its UK-based coverage.
But before the ink was dry on the HSBC purchase agreement, Credit Suisse announced that it had found a “material weakness” in its financial reporting. The bank has been beset by numerous scandals in recent years, including money laundering charges. It reported losses totalling £6.5 billion in 2022 – its worst year since 2008 – and has warned that it does not expect to be profitable until 2024.
Credit Suisse is a domestic bank with some 95 branches, but it also has a global presence as an investment banking operation, managing assets for high-net-worth clients.
With over 50,000 employees and a key role in the international banking system, it is one of those banks deemed “too big to fail”. Following a market sell-off and negotiations with the Swiss government, it was announced that UBS – its principal rival in Switzerland – would acquire the bank for around CHF 3 billion.
Under this historic deal, holders of US$17 billion worth of Credit Suisse bonds will have their investment wiped out. Meanwhile, Swiss financial regulator Finma has ordered that CHF 16 billion of Credit Suisse's additional tier one [AT1] bonds (a riskier class of bank debt) will be written down to zero.
However, several people involved in negotiating the deal have indicated that wiping out the AT1 holders would have wider repercussions and could lead to a sell-off of other bank debt. Others have suggested that Finma’s actions have broken the capital structure and could have long-term consequences for other Swiss financial debt.
Since the announcement regarding the bond holders, US law firm Quinn Emanuel has been approached to try and help investors explore the option of legal action.
Needless to say, some investment professionals are already drawing parallels between the current situation and the Global Financial Crisis. But circumstances are not entirely the same: the regulator stepped in to ensure that customers at SVB and Signature had full access to their money. Similarly, Switzerland’s central bank and UBS moved swiftly to support Credit Suisse. That said, it is unlikely that this episode is entirely over.
It may be the case that we have too many banks – particularly in the US. It is therefore likely that many of the larger banks will hoover up some of the well-run smaller banks at bargain prices as they fall victim to the Federal Reserve Bank's drive to beat inflation at all costs.
How will the Federal Reserve Bank react to the visible signs of stress that higher interest rates are having across the banking sector? Will it ease off on its interest rate hikes? Last month’s inflation data confirmed that its forceful tightening programme was actually beginning to work...
But can it continue to prop up the financial system while continuing to tame inflation? Or should it throw in the towel and inject even more liquidity into the system while core inflation remains well above the target rate of 2%? Essentially, it is caught between a rock and a hard place, and all eyes will be on Jerome Powell at the Fed’s March meeting this week.
In the UK, banking sector troubles have taken centre stage, overshadowing the spring budget statement, which introduced incentives for high-growth businesses (those involved in artificial intelligence and quantum computing). It also introduced some significant changes to pensions designed to encourage older workers back into employment.
Overall, the UK now looks set to avoid recession in 2023. But household living standards are predicted to record their biggest two-year-fall in seven decades. And the tax burden will increase for millions. The stresses and strains of a difficult week hit the UK stock market hard: the FTSE 100 Index – with its heavy weighting towards banks – tumbled by more than 3%.
In Europe, the European Central Bank raised short-term interest rates by 0.50bps, despite recent heightened stress in the banking sector. ECB president Christine Lagarde insisted that the eurozone’s banking system was “resilient with strong capital and liquidity positions”. She added that the ECB’s toolkit was “fully equipped to provide liquidity support to the euro area financial system if needed and to preserve the smooth transmission of monetary policy”.
Yet another period of uncertainty appears to have begun. But we are in significantly better shape than we were in 2007-2009. Indeed, the markets’ overreaction has even provided us with some interesting opportunities. That said, nobody is denying that times such as these are challenging.
Inflection points occur in the market and performance can suffer. Our advice remains the same: stick to your financial plan and remain composed. Now is the time to take advantage of any mispricing – which may well turn out to be what the likes of HSBC and JPMorgan have done.
