ExplainSpeaking | Credit Suisse sold to UBS: Why are banks in turmoil across the world, what are central banks doing about it

A flurry of banking collapses

On March 10, Silicon Valley Bank (SVB), US’ 16-largest bank, collapsed after just a single day of stress following a classic bank run in which depositors demanded as much as $42 billion in one go.

By the time the US regulators came around to dealing with SVB, which was the second-biggest collapse after the iconic Lehman Brothers, another bank called Signature Bank had to be seized after depositors demanded 20% of all its deposits. This made Signature Bank the third largest bank to collapse in the US.

A lot of Signature Bank’s dealing was in cryptocurrencies and regulators believed that unless it was closed down, the run on Signature Bank could spread further. To some extent it did with the share prices of First Republic Bank nosedived within hours.

The US Federal Reserve, the US’ central bank like RBI is in India, tried to get 12 large banks to help First Republic but with each passing day, credit rating agencies have been downgrading First Republic. Overnight, CNBC reported that S&P had downgraded First Republic to junk status while saying that even the $30 billion infusion may not solve the bank’s problems.

What’s happening to banks across the world?

There are two ways to look at these bank collapses.

1. One is to look at the specifics of each bank. When one does that one will find that these banks (that is, their management) are paying the price of either undertaking risky bets or ignoring prudential norms or indulging in outright fraud or a combination of these. All these missteps eventually hit profitability and eroded investor confidence.

Let’s take the case of Credit Suisse.

Read this detailed explainer published in October 2022 when it was widely expected that Credit Suisse was about to collapse. Even though it managed to survive at that time, unfortunately, the news trickling out of Credit Suisse continued to stay negative. For instance, when probed by the US’s market regulator, the Securities and Exchange Commission, Credit Suisse admitted in March this year that the bank’s cash flow statements suffered from “material weakness” (read: inaccuracies).

In the case of Silicon Valley Bank too, there is prima facie evidence of both mismanagement and fraud.

For instance, SVB put almost all its deposits — customer deposits shot up from $60 billion in 2020 to over $200 billion thanks to the tech startup boom that happened in the wake of Covid — in long-term US government bonds. While this seems like a safe investment, it suffered from two problems.

One, it made the bank vulnerable to bank runs because deposits can be withdrawn within hours while the bonds are stuck for the long-term (say 10, 20 or 30 years). Moreover, when SVB bought the long-term bonds, the prevailing interest rates were quite low but in 2022, the US Federal Reserve sharply hiked short-term interest rates. This meant that previously floated long-term bonds (which paid lower interest rate) were worth less. So when SVB decided to sell their long-term bonds prematurely — in order to meet with the withdrawal demands by depositors — it started to book heavy losses.

Further, SVB could not spot this terrible risk in its portfolio because it allowed the position of Chief Risk Officer to stay vacant between April 2022 and January 2023. It is noteworthy that this was precisely the time when the Fed was frantically raising interest rates. But there was no one at SVB to take notice.

The shareholders are also accusing the management of fraud because it has been reported that the top management got its bonuses just before the collapse. In fact, some of the top management even sold their stocks before the collapse.

2. The second way to look at these collapses is to look at the macro picture. The global economy has had a very long period of loose monetary policy (lots of money being printed by central banks and credit being made available at near zero percent interest rate) followed by a sudden and very sharp monetary tightening (read a sharp rise in interest rate across the world as well as reduced money supply).

Just like it is said that a rising tide (economies being flooded with cheap money) lifts all boats, similarly a fast receding tide is starting to leave many boats stranded. Cheap money allowed banks and businesses to undertake risky bets. Many are realising they do not have enough time to deal with the sudden spike in funding cost. At one level, the spike in interest rate is too much and happening all too fast for banks and businesses to adjust and recalibrate their actions.

That is why you might be reading of growing fears of recession and financial instability.

To be sure, economic booms fuelled by extended periods of cheap credit often culminate in economic collapses. In the book titled “The price of time: The real story of interest”, Edward Chancellor writes: “Modern central bankers fret about the twin evils of inflation and deflation. Their goal is to achieve a stable price level. Yet over the past hundred years, several great credit booms – including the credit boom of the 1920s, Japan’s bubble economy of the 1980s and the global credit bubble preceding the 2008 Lehman crisis – have occurred at times when inflation was quiescent. On each of these occasions, the lack of inflation encouraged central banks to maintain interest rates below the economy’s growth rate. Each of these credit booms ended in disaster.”

What is the US Fed and the other central banks doing to arrest the contagion?

Any financial system runs on trust. If that trust is shaken, things like a bank run can happen. To be sure, a bank run essentially means all depositors wanting to withdraw their money at the same time. Of course, no bank can furnish such a demand because banks don’t sit on all the money they get from depositors; instead they lend it out to earn some income of their own.

The collapse of these banks has eroded that trust. People and policymakers alike are worried about the spread of this contagion.

In particular, the central banks across the world are caught in a tough spot. On the one hand their primary mandate is to bring down inflation and restore price stability in the economy. On the other hand, they are finding that their sharp monetary tightening is increasingly catching banks and financial players off-guard.

While it is true that central banks want the economies to slow down so that inflation comes down, what is happening is quite worse. Sudden bank runs and collapses point to the possibility of people losing confidence in the banking and financial system. While this will also slow down the economy, it would be a particularly bad way of slowing down the economy because it would come at the cost of people’s confidence in the system, which takes much longer to reestablish, than just recouping some amount of GDP growth.

To be sure, the situation is not as bad as the 2008 crisis when the underlying asset itself — the home mortgages — were losing value. Still, central banks are aware that sudden bank runs and ensuing panic can derail even the most robust financial system.

As such, immediately following the sale of Credit Suisse, the US Federal Reserve shared a press release that stated: “The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing a coordinated action to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements.”

In simple language, key central banks have come together to ensure that US dollars can flow from one bank to another in case dollars are needed. This is an emergency arrangement and is aimed to not just calm the down jittery consumers but also bolster the confidence of nervous policymakers and bankers.

What lies ahead?

Despite the imminent fall of Credit Suisse, the European Central Bank decided to rate interest rates by 50 basis points last week.

This week, on March 22, the US Fed is supposed to unveil its monetary policy review.

Before the collapse of the Silicon Valley Bank, most observers expected another 50 basis points increase from the Fed. That’s because US inflation has not decelerated as fast as the Fed wanted.

But the events of the past 10 days have thrown the proverbial spanner. As the actions of last night suggest, the Fed and other central banks are acutely concerned about the financial system getting frozen and banks running out of money because of sudden runs. In such a scenario, raising interest rates may be considered very risky because it will further raise borrowing costs.

However, if the Fed pauses its fight against inflation, it may well worsen the inflation problem.

So it all depends on how the Fed reads the situation.

If the Fed believes that the banking and financial system is essentially robust and that it can easily deal with one or two faltering banks by providing them liquidity support then it could decide to stick to its path of monetary tightening and possibly raise interest rates by 25 basis points instead of 50.

If it believes the financial system is in grave danger, it may decide to pause.

Either way, expect more turmoil in the coming days especially in terms of stock market behaviour.

Share your thoughts and queries at udit.misra@expressindia.com.

Until next week,

Udit