There are two arms to banking – there is the bread and butter of banking, namely facilitating money transactions for the users of the bank. Then there is investment banking where the bank uses depositors’ money to invest in financial products that will generate a profit for the bank and its shareholders.
The issue with this second type of banking is that it is essentially gambling with other people’s money. This is allowed. Central banks and governments set reserve limits for banks: as long as the bank has 8% of the total deposit amount in its vaults, it is allowed to use the other 92% on investments such as government bonds, interest paying loans and cryptocurrency-related products.
Under normal circumstances the reserve limit is effective. Only a fraction of depositors at any one time will ask for their money, and there is enough on hand to fulfil their clients’ requests. However, the situation goes awry when negative publicity is directed at a bank. Thanks to the internet and the advanced state of modern interconnectivity rumours spread immediately, depositors get spooked and use their mobile app to transfer their funds out of the bank. Bank runs used to be characterised by mobs of angry people outside of banks desperate to see a teller and effect a bank transfer or cash withdrawal. Now depositors can order cash transfers online and banks can do nothing to prevent huge exoduses of money in a matter of hours, other than by shutting down remote banking aps.
Rewind to 2008
In 2008 we had what was quickly dubbed ‘the global financial crisis’. The year started out with worrying news that there had been a sharp drop in house sales in the USA. At the same time house prices fell 4.6% from the previous year. The story rumbled on and gathered apace as the year progressed. The government bailed out the bond market. Fannie Mae and Freddie Mac tried to shore up the mortgage market by taking on $200 billion of subprime mortgage debt. IndyMac bank in the USA failed in July. No one could be in denial that they were in the heart of a financial crisis when Lehmann Brothers bank filed for bankruptcy in August 2008. And thus, it unfolded: with a steady trickle of information coming to light about banks taking on risky products such as securities composed of sub-prime mortgages. Financial institutions made the situation worse by offering hedges against their own products with credit-default swaps.
The general public panicked and tried to withdraw their savings or sell their homes. Foreclosures went through the roof. Governments around the world were forced to step in and bail out banks to secure depositors’ money and prevent the possibility of riots.
The interesting thing to note about the 2008 banking crisis is that up until autumn commentators were trying to downplay the bad news and the Fed and central banks around the world provided financial help to ailing institutions to bolster the narrative of ‘nothing to see here’. Tragically there was a lot to see there.
Fast Forward to 2023
After the crash of 2008 when millions lost their jobs and homes and deep recession loomed. Bankers around the world decided the best way to get out of the financial hole they were in was to keep interest rates low. Governments did their part by pumping billions of dollars into quantitative easing schemes to keep the stock markets buoyant. In short, the cost of borrowing money was cheap – just 0.25% or less.
The ‘cheap money’ was great for venture capitalists as well as for the public that could secure cheap mortgages. There weren’t any notable economic booms but neither were there any more financial meltdowns. That was until March 2023.
First Silvergate Bank went bankrupt. Then Signature Bank went under. Both of these banks were darlings of the crypto universe which had been hit by a cryptocurrency winter starting the previous year, and was compounded by the high profile collapse of FTX crypto exchange amidst allegations of fraud and mismanagement. Then in March the tech-facing Silicon Valley Bank (SVB) in California needed to be taken over by the Fed. The UK government in just 2 days transferred SVB UK to Barclays to guarantee depositors’ money. Shareholders did not get a bail out.
Financial commentators, just as in 2008, were shaken out of their complacency when TV broadcast scenes of angry depositors outside banks demanding their money. Joe Biden stepped in to reassure the nation that their money was safe. The UK government did the same.
The belief is that cool heads will prevail. And mainstream media went with the narrative that decisive government and central bank action had avoided a financial collapse. Europeans were reassured that the ‘contagion’ of bank runs would not cross the pond. It was just an American problem.
However, on March 16th 2023 stories started to appear in the financial columns of newspapers about the travails of Credit Suisse Bank – one of the five mega banks in the world. A mega bank has its fingers in so many pies, is so big that it is deemed too big to fail. A Saudi consortium who had purchased 9% of Credit Suisse Bank fanned the nascent flames of fear by declaring it wouldn’t provide emergency liquidity for Credit Suisse. Within hours the Swiss Central Bank bailed out Credit Suisse out with over $50 billion.
Again, nothing to see here. We have it under control. That is the state of play as I write. I couldn’t be more worried – Barclays, CitiGroup, JP Morgan, Bank of America are also mega banks considered too fundamental to the financial universe to fail. How do their balance sheets look?
The situation is unclear. Credit Suisse has its own unique issues. Namely, they have been periodically rocked by scandals since the start of the new millennia, receiving huge fines for laundering Bulgarian drug money, for helping depositors avoid US taxes, for hiding the stolen wealth of the Marcos family in Indonesia, for helping a Nigerian dictator. The list is impressively long. It is hard to conceive of a bank more mired in corruption in modern times.
This makes Credit Suisse unique, and points to a possible end point to what appears to be an increasingly unstable situation.
Putting aside the particulars of why Silvergate, Signature and SVB went under, and why Credit Suisse limps on, there is an important macro-trend to consider. This is interest rates. Since the crash of 2008 they have been historically low. Government bonds, usually a safe harbour for money, offered only 2% or less returns.
Since the end of the 2008 crash, banks have quietly increased their exposure to risk, focusing less on retail banking and more on investment banking. And freed of much of the regulation imposed on them after the 2008 crash, they have loaded up on government bonds as secure investments.
The problem is that the covid-19 pandemic, followed by supply chain issues and then the war in Ukraine that removed the world’s second biggest supplier of oil and gas from international markets all placed strains on the global economy. The result was sharp inflation. Everything cost more and so people’s living standards went down. Demand for wage increases fuelled the escalating inflation.
Central banks took action to control inflation by raising central interest rates. Inflation has since then appeared to peak but the damage has been done. Banks holding large percentages of their reserves in low yielding government bonds have a big problem. Namely, that new government bonds are offering much higher rates. This means the majority of their bond offerings are unsellable.
If a bank can hold bonds until maturity there is no loss in terms of accounting. If, however, depositors demand their money then the bank has to sell these bonds at a loss to cover its liabilities. This is the systemic problem with banking: they have an unconscious bias that tomorrow will be like yesterday. Added to this pressure from shareholders to maximise profits and you are left in a situation where risk is increased to chase small margin gains.
The key lesson to be learnt from the present banking predicament is that banks have to pay more attention to risk management. Capitalism in its present neo-liberal guise in the USA and Europe equates regulatory handrails as bad for business. The mantra is less regulation equals more profits.
The problem with this ethos is that handrails are there for a very good reason. If you slip you have a better chance of avoiding falling to your death.
In many ways the current malaise is a direct result of the low inflation environment caused by the 2008 crash and the ensuing economic slowdown. Some sought to beat the trend by riding the crypto boom, others sought to lock in long term profit with low yielding government bonds. Both strategies, in hindsight, seem flawed to say the least.
The financial world has the benefit of artificial intelligence, computer learning and sophisticated modelling programs. The world’s money can be managed by computers and transactions can be virtually frictionless thanks to internet banking. Are analysts fooled by their own brilliance into thinking 2008 cannot happen again? In the last century ‘prudence’ was the gold standard for banking credibility. Prudence would tell you not to put all your eggs in one basket.