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22 March 2023

Fear grips the markets

After three US banks collapsed in a week, the global financial system is facing a new set of systemic risks.

By Will Dunn

In the summer of 2021, at an office in Santa Clara, California, a series of choices were made that would come to have profound consequences for the global economy. The decisions were taken by the treasury management team at Silicon Valley Bank (SVB), which was riding high: borrowing was cheap, venture capitalists were pouring money into technology start-ups, and those companies mostly deposited it at SVB. In a single year SVB’s assets had almost doubled to more than $210bn.

The bank’s executives decided to invest in what looked like the safest assets in the market: long-dated securities, which pay a fixed return for ten years or more. But the way in which they did so amounted to an unsecured $91bn bet that interest rates in the US would remain at historic lows, as they had for nearly 13 years.

It was a bad bet. In 2022, the effects of the pandemic (and the monetary response to it) unleashed a wave of inflation which central bankers initially assumed would pass. When it didn’t they began raising interest rates faster than at any point in recent decades. As the price of debt took off, so did SVB’s “unrealised losses” – the amount that the bank stood to lose from selling off its now underperforming assets.

[See also: A reckoning for Silicon Valley]

On 8 March, SVB announced that it had begun trying to fix its balance sheet by selling off some of the bad bets at a $1.8bn loss, which it hoped to cover by selling $2.2bn in new shares. It never got the chance. In after-hours trading, the Californian bank lost 60 per cent of its market value and when it opened the following day, its depositors – a relatively small group of well-informed, closely networked companies and individuals, mostly with large deposits – began taking out their funds. In a single day, $42bn in deposits were withdrawn: the biggest and fastest bank run in history.

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The next day, SVB was taken over by regulators in the US and its UK subsidiary, Silicon Valley Bank UK, was placed into receivership by the Bank of England. Meanwhile, customers at another US bank – ­Signature, which had $110bn in assets – withdrew 20 per cent of all deposits. By 12 March, it too had been closed, by a regulator who cited “a significant crisis of confidence in the bank’s leadership”.

Other mid-sized or “regional” US banks began to look shaky: First Republic received $30bn from the US’s biggest banks as its ­credit rating was cut, its stock price plunged and customers withdrew their deposits. The panic spread beyond the US as bank stocks fell globally. In Europe, investors’ attention turned to a bank that had become synonymous with poor leadership: Credit Suisse, Switzerland’s second-largest lender. 

[See also: Who killed Silicon Valley Bank?]

Despite a series of scandals that included accusations of having provided services to dictators, money launderers and drug barons, as well as corporate espionage among its executives, Credit Suisse was still designated as a global systemically important bank (or G-SIB). Its assets were worth more than half a trillion dollars. Investors might have forgiven Credit Suisse – or Debit Suisse, as it began to be called – its scandals, but its own bad bets on institutions such as Archegos and Greensill and its overall losses, which came to £6.6bn last year, were another matter.

The bank’s fate was sealed when its biggest backer, the Saudi National Bank, ruled out a further cash injection. On 16 March the Swiss National Bank supplied £45bn in emergency liquidity, to Credit Suisse – the first of the G-SIBs to receive a bailout since 2008 – while the Swiss authorities began hurriedly rewriting the country’s laws to allow a takeover by its main rival, UBS. 

The saving of Credit Suisse came at a cost: a large portion of its debt was written off in the merger, at a price to investors of almost $17bn. On 20 March, as financial markets rose in relief at news of the rescue, Marko Kolanovic, the chief market strategist at JP Morgan, warned that a “Minksy moment” – in which a speculative bubble disintegrates under the rising cost of the debt that inflated it – is now becoming more likely.

This is a complex global situation and it is impossible to predict accurately what will happen next, but it is based on a single cause. For almost 15 years, monetary policy has kept financial risk on ice. With real interest rates held below zero, the banking system adapted to a set of abnormal conditions as if they were permanent. Now, the return of inflation has brought with it an abrupt raising of the temperature, a repricing of almost everything in financial markets – and a risk of meltdown.

[See also: The “world’s next Silicon Valley” is unlikely to be in Britain]

The most common question is: is this 2008 again? The short answer is no. The group of 30 G-SIBs to which Credit Suisse belongs has much more stringent requirements for the losses they must be able to absorb and the processes they follow if they do need to be wound down. Domestic regulation is also much tighter than before the financial crisis, and – after the damage inflicted on Britain’s banking sector in 2008 – this is especially true in the United Kingdom. One banker who was at RBS during 2008 told me the current crisis “feels very different”, because big banks are far better capitalised and better run.

Yet there is no shortage of frightening numbers. Days before the run on Silicon Valley Bank, Martin Gruenberg, the chair of the Federal Deposit Insurance Corporation (which insures the bank deposits of Americans up to $250,000 each), gave a speech in which he estimated that if all the losses from the sharp turnaround in interest rates were realised, the US banking sector would lose $620bn. Worldwide, the market value of banks has fallen, at the time of writing, by $459bn since the beginning of March.

Stephen Miran was a senior adviser at the US Treasury when the Covid pandemic began in early 2020, causing an initial rout in global markets. He now works in the banking sector, where, he told me, there is “more uncertainty than there has been at any moment since the depths of the pandemic”. 

But Miran believes the current conditions are less like 2008 and more like what happened in the late 1980s, when the savings and loan crisis wiped out more than 1,000 smaller lenders across the US. Then, as now, a sudden rise in interest rates in response to inflation turned the long-term assets (mostly mortgages) held by these smaller institutions from a source of profits to a rising cost. “What we’re seeing is that the weakness and stress is being concentrated in smaller and more vulnerable banks,” Miran said. “There’s a chance that we wind up losing several more before this is over.”

[See also: Silicon Valley Bank unmasks the hypocrisy of libertarian tech bros]

The US is not the only country in which regional banks are significant. In Germany’s credit cooperatives and Japan’s Shinkin banks – local institutions that serve small businesses and homeowners – the same interest-rate risk is arising as their assets are made unprofitable by the war on inflation

But while there are echoes of the 1980s, this is also something entirely new: a banking crisis in a world with emerging systemic risks and with a war raging in Europe. The 2008 crash occurred after a long period of stability, an apparent Great Moderation, in which many policymakers assumed risk had been tamed; the current crisis is happening in a world economy struggling to recover from a pandemic and in which Vladimir Putin’s Russia has invaded Ukraine.

In 2008, the technical and social networks on which information travels were very different. WhatsApp did not exist, Twitter and even Facebook were relatively niche platforms, and the iPhone was an expensive luxury. These technologies have radically changed the speed of what the economist Robert Shiller – who won a Nobel prize for his work predicting the dotcom crash – calls “narrative economics”. Shiller’s work shows that the conditions for events such as the 1929 Wall Street Crash were laid not only by the blind arithmetic of the market but by millions of conversations, on trains and at dinner tables, about the investment decisions of everyone in the economy. 

Technology has made these conversations more public and easier to profit from. When debt is cheap and stocks are booming, people can be encouraged to gamble on speculative mania; when rates rise and the system comes under pressure, the ­hawkers of cryptocurrency can claim their financial snake-oil is the cure (it isn’t – Bitcoin is wholly uninsured and its price is demonstrably manipulated).

As Mervyn King, the former governor of the Bank of England, observed, it is never rational to start a bank run, but it is rational to join one. In today’s information environment, depositors and investors have many more competing signals and much less time to decide what’s rational and what isn’t. There has never been a more fertile ground for panic. 

[See also: Inside the Silicon Valley Bank UK crisis]

The response from governments and regulators has, reassuringly, been faster and more significant than in the early stages of the 2008 financial crisis. During the week of SVB’s collapse, the US government loaned half as much money to banks as it did during all of 2008, providing $300bn in liquidity to prevent contagion taking hold. Around half of this was loaned to government-created companies that secured the deposits of failed banks, while the other half was issued through the Fed’s “discount window”, which provides cheap, short-term lending to financial institutions. In a normal week, the US’s banks would use the discount window to raise up to $5bn; during the week of SVB’s demise, they borrowed $153bn.

Politically, the task is to claim that this is not a bailout. In a speech on 13 March, US president Joe Biden announced that the management of SVB and Signature would be fired, and investors in the banks’ securities would not be compensated – “that’s how capitalism works”, he observed. But the venture capitalists and their portfolio companies who had been depositors in those banks would be fully bailed out. Biden repeated for emphasis that “no losses will be borne by the taxpayers”, but this wasn’t entirely true: as the president acknowledged, it would come from the deposit insurance fees charged to banks. What Biden didn’t say was that this would result in more expensive debt across the economy and possibly the world. 

Not everyone thinks bailing out SVB’s depositors was a good idea. One American financier told me: “there were billionaires who had $50m deposits in SVB. These are not Mom and Pop, these are companies owned by venture capital.” These firms could have done a better job of managing their own risk rather than concentrating their funds in a single institution focused on speculative technology. “Inflation is 6 per cent. The economy is still overheated,” the banker told me. “If there ever were a time to allow the system to work as designed, and not be engaging in endless bailouts, this is it.”

One way to avoid being seen to rescue reckless banks – thus creating the moral hazard of underwriting bad behaviour – is for governments to make it look as if banks are being “rescued” by one another. This is surely why the Federal Reserve is lending money to JP Morgan to lend to First Republic, and why the Swiss government brokered the takeover of Credit Suisse.

However, a side effect of these state interventions is that depositors know the big banks are being propped up in a way the regional banks aren’t, and are moving their money accordingly. While the big banks are keen to avoid contagion, Stephen Miran warns their generosity might not last. 

In 2008, the US’s biggest banks bought Washington Mutual and Bear Stearns, principally to mitigate the unfolding disaster, only to be fined billions of dollars for the actions of the banks they had bought. Their response to regulators, Miran says, became: “We bought this pile of crap from you, in order to help you – and then you spend years attacking us and imposing fines on us for things those idiots did.” This time around, he warns, there might be “a natural resistance to buying banks”, and a preference for picking up their assets after they fail. Either way, the likelihood is that if the crisis deepens, the global banking system will emerge from it smaller, more top-heavy – and more vulnerable to the next crisis. 

[See also: Why did Silicon Valley Bank collapse?]

In the UK, the true madness of this situation is that the British government is trying to impose deregulation on our financial services industry. The Edinburgh Reforms, described by the Treasury as a “once-in-a-generation opportunity to become more nimble, agile and proportionate”, is a package of proposals that will remove some of the most important measures implemented after the 2008 crisis.

The Financial Services and Markets Bill (which is being debated in the House of Lords) imposes a new statutory duty for regulators to consider the competitiveness of the ­financial industry – not its stability or good governance – as their first priority. Under it, bodies such as the Financial Conduct Authority would become “cheerleaders for the industry they’re supposed to be watchdogs over”, said Jesse Griffiths, the CEO of the banking think tank the Finance Innovation Lab. 

Other proposed measures include the removal of the requirement to “ring-fence” the riskier investment operations of a bank from its consumer banking arm, and to remove measures that hold senior executive personally responsible for the kind of behaviour that imperilled Credit Suisse. But Griffiths is most concerned by the plan to reduce the amount of capital that insurance companies are required to hold (the “Solvency II” regulations). 

“The government says it’s going to free up £100bn of capital for investment in the UK,” Griffiths said. “But that capital is set aside to protect us from the collapse of big insurance companies. That’s not freeing up the capital, it’s taking capital to protect us from risks and giving it back to insurance companies.”

In fact, the risk to the British economy may emerge from the less regulated parts of the system, in financial intermediaries or “shadow banks”. Private equity companies and debt funds took an increasingly important role in financing British businesses after 2008, and greatly expanded their acquisitions during the pandemic investment boom, but it’s harder to say how much interest-rate risk these opaque institutions carry and how it might suddenly spill over into the wider economy. 

In the wake of the 2008 crash, as governments reined in their spending, central bankers took it upon themselves to try to stimulate economic growth by making debt as cheap as possible. When risk appeared in financial markets, it was doused with the liquid nitrogen of near-zero interest rates and quantitative easing. This fuelled an unprecedented boom in asset prices, as the freezing of risk in the market underwrote a decade of speculation. But rising inflation has brought the good times to an end. 

There’s a good chance that the current crisis will cause rising interest rates to pause or slow down, but this will have to be balanced against the threat of rising prices. Having waited and watched as inflation grew – the Bank of England did not raise the bank rate above 1 per cent until inflation was almost in double digits – central banks have little choice but to continue the struggle against it. But in doing so, they cannot help but load more pressure onto a creaking financial system.

The answer may be found in a “dual-track” policy of stabilising financial institutions while fighting inflation – but voters may decide to understand this as bailing out banks while making mortgages more expensive. Whether this averts a new crash or not, the sharp risks of the banking system will make their way out to the rest of us: that, as Joe Biden might more truthfully have said, is how capitalism works.

[See also: How 2022 killed the myth of the tech genius]

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This article appears in the 22 Mar 2023 issue of the New Statesman, Banks on the brink