Recap on Recent Banking Events
Written the evening of Sunday March 19.
A bank’s primary function is to take deposits and lend to those who need funds, whether it’s an individual with a mortgage or a company looking to grow their business. They are paid to take risk for a fee. In the meantime, they have to ensure they have a diverse client base, whether that is through geography, sector exposure or via customer concentration. Banking is all about confidence and trust. A customer must have full faith and 100% confidence about their funds.
Risks Faced by Banks
There are for primary risks that banks face.
The first is credit risk. Banks are exposed to losses when borrowers default on their loans. This is what happened, for example, during the Great Financial Crisis in 2008. Real estate borrowers were highly leveraged and defaulted, imposing losses on institutions that had specialized in real estate lending.
The second form of risk is interest rate risk. This is incurred when lenders borrow short term and lend long term. When interest rates rise, short-term funding costs increase, while returns on long-term assets don’t increase in parallel fashion. This puts a squeeze on profits and potentially results in losses great enough to cause an institution to fail. This is exactly what happened during the S&L crisis in the late 1980s and early 1990s, when nearly a third of all S&Ls failed. The roots of the crisis were deregulation of thrift institutions, aggressive lending into a real estate bubble that burst, and speculation.
The third risk is liquidity risk. When institutions face withdrawals of funds and do not have access to sufficiently salable assets to meet withdrawal demands. Usually, liquidity risk results when institutions attempt to respond to the losses imposed when depositors realize that the costs of interest rate risks may impact their ability to access their funds and seek to withdraw them. Liquidity risk is especially important when institutions have large amounts of uninsured deposits.
Finally, the fourth risk is fraud risk. This is when management engages in illegal activities.
Recent Stress on US Regional Banks & Credit Suisse
Silicon Valley Bank (SVB), which was the 16th largest bank in the US and who’s predominant customers where venture capital funds and private equity tech companies, and Signature Bank (SBNY) both had a ‘run on the bank’ as they had 90/94% of their deposits above insurable limits.
SVB was exposed to significant interest rate and liquidity risks that resulted in a run on the bank. Banks take their deposits and invest in Treasuries (short-term fixed income) or other bonds (medium to longer term) to earn a better yield. On the asset side, SVB had 57% of its assets in Treasuries and agency securities booked at low yields before the Fed began raising rates, thus exposing the bank to significant interest-rate risk. The problem was made worse because about 94% of its liabilities were in the form of uninsured deposits. By comparison, the median percentage for the ten largest US banks is about 46%.
Source: SEC - Interest Rate Risk - When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall.
Again, this meant that the bank’s liabilities were not diversified, and the key is to have a diverse depositor base, not only geographically but also including smaller retail accounts, which are sticky and not as likely to run. So, in SVB’s case, the company committed two cardinal sins by shunning the principles of both asset and liability diversification, exposing the bank to interest-rate risk and bank runs. As a result of poor decisions, these institutions were exposed to interest rate risk and liquidity risk which exposed their companies to huge short-term risk.
Meanwhile, Credit Suisse was the 3rd largest bank in Switzerland, and they were one of the Global Systemically Important Banks. They would be included in the same bucket as a Royal Bank, ING or a TD Bank. They have been in a secular decline though and at the end of 2022 they had $600 billion in assets down from $800 billion a year prior and $1 trillion in assets at the end of 2014. The problem with Credit Suisse over the years has been poor leadership of the organization and an inability to put the firm on sounder financial ground. The company lacked consistency in setting goals, incentivizing staff, and managing risk which has resulted in the firm’s legal issues and having to pay over $11 billion (USD) in fines and penalties since 2000.
Fed Moves & Markets
The Fed is going to announce their decision on interest rates on March 22nd. Two weeks ago, the market was leaning towards a 0.50% rate increase. Now the decision is between either 0.25% increase or pause and stay on hold until the next meeting in May. Inflation is still a big concern and a key focus of the Fed. However, the timeline for when they will end the rate hiking cycle – when inflation rate is firmly trending lower and the economy is slowing down, has had a wrench thrown into it over the last 10 days, as they now must consider if all the rate hikes are leading to problems in the banking system.
Where does that leave us with stock markets?
The S&P Index was up 1.4% last week and the Nasdaq index was up 4.4% (and a one month high on Thursday). What is more important than the news, is the market’s reaction to the news. Maybe we will see a quicker end to the rate hiking cycle? The Nasdaq is less exposed to financials, and more mega cap tech with stable reliable earnings. Lower rates mean investors buy tech stocks. Markets are moving very quickly though, and the best sign would be to see markets shrug continue to shrug this recent stress off.
Speaking of markets moving fast, they are moving much faster than they have in the past. One reason is social media as news, rumors and misinformation now travel instantly. As hard as it might be to believe, we didn’t really have social media 15 years ago!
This also means that Central banks, Governments, and regulators can come together in a weekend to ensure depositors are protected like we saw last week or to work out a framework agreement for UBS to acquire Credit Suisse in a weekend. Unbelievably fast co-coordination, was missing in the 2008-2009 Global Financial Crisis.
Eventually though markets price in the bad news and start to look forward. It’s possible that there’s already been a lot of bad news that has wrung out sentiment without a meaningful breakdown in price. Only time will tell, and we want to see calmer markets.
Also of note, the Ontario provincial budget will be announced on Thursday March 23 and the Federal budget update will be released on Tuesday March 28, which could result in some tax changes for Canadians.
Lastly, if you have any questions or concerns, please get in touch with someone on the team. While we don’t have all the answers, we can impart some wisdom on navigating periods of market stress along with a reminder that keeping calm and rational is especially important when news is happening fast and changing by the hour or day. It may take some time, but things will work themselves out.
Source: NBI CIO Office Quarterly Flip Charts.