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The collapse of Silicon Valley Bank (SVB), sent ripples across the entire banking industry and caused the closure of another two banks; Signature Bank and Silvergate Bank in the US. The ongoing turbulence in the US banking industry is raising the prospect of more failures. According to a paper published by the Social Science Network, nearly 200 US banks face similar risks that led to the collapse of SVB.
The current bank crisis started with the failure of Silvergate Bank on March 8. Two days later US regulators closed SVB and after another two days, Signature Bank. The latter two are considered as the second and third largest bank failures in US banking history. SVB was primarily focused on start-up business in the San Francisco Bay area. Other two banks were primarily focused on crypto currency clients.
Now increased attention has turned to the woes of First Republic Bank with growing concerns that it could be the next. The week before last, 11 major banks led by JP morgan with the support from the US Treasury decided to deposit US$30 billion with First Republic to alleviate concerns that like the SVB have problems meeting depositors claims.
Financial authorities in the US teamed up immediately following the collapse of SVB, the 16th largest bank in the country to protect the depositors of failed US lenders. The US Federal Reserve (the Fed), Federal Deposit Insurance Corporation (FDIC) and the US Department of Treasury unveiled an emergency plan to avert a financial disaster.
The programme essentially includes the guarantee of all deposits regardless of the amount. Previously, the FIDC insured only up to US$250,000, now those whose holdings exceed this amount can also be able to access their money.
The Fed has created a facility of last resort to lend money to banks that they need. Basically, the Fed is ready to print as much money as possible to avoid a financial crisis like the one in 2008. President Joe Biden also weighed in and said "Americans can have confidence that the banking system is safe".
President Biden also stressed that SVB was not getting a bailout but the decision to guarantee all the deposits at SVB was for all practical purposes a bailout. In fact, the Fed created a whole new bailout system to ensure that banks do not lose money on their bad investment and lending decisions. Many point out that the banks rely on "big government while demanding austerity from for rest of us".
US Treasury Secretary Janet Yellen in a speech last Monday to the American Bankers Association also assured that the bailout of uninsured depositors was not focused on aiding specific banks or classes of banks but would be extended if that were considered necessary if smaller institutions suffer deposit runs that pose the risk of contagion.
The core problem for SVB collapse lies in rising interest rates which have been increased by the Fed to combat rising inflation. Many of its assets, such as bonds and mortgage backed securities, lost market value as rates climbed.
The US$9 trillion quantitative easing (QE) fuelled an asset price inflation. QE led to interest rates falling below 1 per cent. As a consequence, the US economy experienced the largest bond market boom in history. The value of the Treasury bond and mortgage backed securities purchased during this period of QE were essentially free money held on their books. As the Fed started to raise interest rates to fight inflation, bond prices crashed. Now many banks assets fell below their deposit liabilities, thus unable to fulfil their financial obligations.
SVB invested in government guaranteed residential mortgages and also bought bonds during the pandemic at very low interest rates. But interest rates jumped quite rapidly since March 2022 to fight inflation. Since bond prices are inversely related to interest rates, or more precisely when interest rates rise, bond prices fall (and stock prices tend to follow), with the rising interest rates, older bonds could only be sold at much lower prices than new bonds that carry higher rates. As for mortgages, when interest rates go up, people tend not to pay off their mortgages early by refinancing, or even may default.
Furthermore, yields on two-year US Treasury notes currently are significantly higher than banks pay on deposits at 5 per cent relative 0.2 per cent on bank deposit. No wonder people take money out of banks to invest in bonds. But that also now has been thrown into chaos as the Fed is dithering about further interest rate rise and its magnitude. The yield on two year Treasury note has dropped from 5 per cent to under 4 per cent last week.
In Europe the focus is now on collapsing of the major Swiss global bank Credit Suisse. The problem is thus now not just US regional bank-centric, but rapidly becoming global. US financial markets experienced major turbulence as the Swiss National Bank, the country's central bank, announced it would provide liquidity to Credit Suisse after its one of the major investors, the Saudi National Bank (holds 10 per cent of its shares) refused to extend any more financial assistance. Two other unmentioned EU banks are reported to be also in trouble.
The news that Credit Suisse with significant business operations in the US requires central bank support is deepening the crisis in the US. In fact, if Credit Suisse were to fail or experience further significant financial problems, the ramification would be far greater than those resulting from the current banking crisis.
Over the last weekend banks, central banks and their government regulators on both sides of the Atlantic gathered to figure out how to stem the crisis of confidence in their banking systems. Meanwhile, in an emergency measure the Swiss government, the Swiss National bank and the country's financial regulator organised the sale of the beleaguered Credit Suisse to UBS. As of June 2022, UBS is the third largest bank in Europe with a market capitalisation of US$63 billion.
The deal arranged by the Swiss National Bank forcing Credit Suisse to merge with UBS involved an unprecedented action. Instead of shareholders losing all their equity and bond holders to recover some of their losses from the sale of remaining assets, as typically occur when a bank or corporation collapses; but in the takeover of Credit Suisse, these rules were overturned. Now the holders of US$17 billion worth of Credit Suisse junk bonds (AT1) would get nothing while equity holder of Credit Suisse will receive a partial bailout of US$3.3 billion.
It has been suggested by a columnist of the Financial Times that the reason for such reversal of the rule was to ensure that powerful Saudi investors (the Saudi National Bank) are compensated-- however modest that might be so as not to offend them.
The Bank of England (BoE) and the European Central Bank (ECB) both criticised the Swiss decision and ECB President Christine Legarde told the European Parliament that Switzerland does not set the standard in Europe. Both the BoE and the ECB emphasised that there is a statutory obligation in which shareholders and creditors should bear losses. Only after their full use, bond holders are to be written down.
The Swiss National Bank has provided UBS with US$100 billion loan and the Swiss government another US$9 billion guarantee. Yet like in the US, the Swiss finance minister Karin Keller Sutter claimed it was not a bailout but a commercial solution. She also emphasised the global implications of the Credit Suisse crisis legitimising further the non-market solution to the current banking crisis.
The emergency Credit Suisse fix with the inverted capital bailout - shareholders first and nothing for bondholders roiling the bond market which is likely to lead to financial instability in bond markets. Contagion at big banks may be contained through the deals made in Europe but contagion in the European bond markets may now exacerbate.
In the middle of a banking crisis and also the fact that the banking crisis has been caused by rising interest rates, the ECB raised its main rate to 3 per cent on March 16. ECB president Christine Legarde justified the rise that it was necessary to bring inflation down to 2 per cent by 2025.
In the US, if the Fed continues to raise interest rates to lower inflation to its target rate of 2 per cent, that may lead to further instability for many regional banks. But not to do so now will negatively impact on its credibility to fight inflation. Under such a monetary policy framework, it is likely that more regional banks may face difficulties. So the Fed and the US Treasury will have to keep up their bailout measures continually should more regional banks get into trouble.
The Fed last Wednesday (March 22) raised interest rates again by 25 basis points (0.25 per cent point) citing the "extremely tight" labour market as the main reason and inflation also hit 6 per cent year over year in February, pushing the federal fund rate to a target range of 4.75 per cent to 5 per cent. Federal Reserve Chairman Jerome Powell acknowledged that the turmoil was leading to significant tightening in credit conditions. Tighter credit conditions will have the same impact on the economy as interest rate hikes, so monetary policy "may have less work to do", implicitly hinting that interest rate increases are possibly at the near end.