Flash crash at SVB to trigger long-run credit crunch

Events at Silicon Valley Bank and Credit Suisse were contained but could they be indicative of another financial crisis to come?

Few economists are adamantly contending that we are barrelling towards a financial crisis on the scale of what happened in 2007-2008 but the small banks crisis has exposed a weakness after interest rate rises that is set to crunch credit for the years ahead.

Mohamed El-Erian from Queens’ College at the University of Cambridge told The National that the SVB-Credit Suisse saga is a reminder of the “fragility of the system.”

“The recent banking system tremors are likely to lead to less credit extension to the real economy as banks become more cautious, as regulation is tightened, and as banks that lost deposits realign their balance sheets,” he said. “This will constitute an additional headwind to growth. And it was largely avoidable, as were the earlier policy mistakes.”

At the time of year when economists, central bankers and those in the investment businesses take stock of the first quarter at spring meetings of the International Monetary Fund and the World Bank, the recent turmoil in the banking and financial sector is hotly contested.

The SVB-Credit Suisse event will probably “worsen the [economic] growth outlook by 0.5 per cent or so — bad, but not terrible,” Ricardo Caballero, Ford International Professor of Economics at the Massachusetts Institute of Technology, told The National. “It feels more like the 1980s — a slow-moving credit crunch ahead rather than a full-blown financial panic.”

“The rate hikes have been very fast, which has led to a steady migration of flows out of deposits into [money-market funds] and treasuries.”

In the US, UK and Europe, it was a bleak start to the year. Wholesale energy prices were rampant, inflation was soaring and central banks had spent many months — more than a year in some cases — raising interest rates.

Recessions, albeit short and shallow, were predicted, and while unemployment was relatively subdued, labour markets were tight.

But by mid-March a liquidity problem with a bank that had specialised in providing finance to the technology sector, Silicon Valley Bank, began to emerge.

Shortly afterwards Signature Bank, which was linked to cryptocurrency companies, started to creak. Then long-standing issues at Credit Suisse forced it into a fire sale to Swiss rival UBS.

People started to ask — is this another financial crisis? Where’s the next Lehman Brothers? Are taxpayers going to have to bail out another series of financial giants that were deemed “too big to fail”?

There are scores of jokes about economists. One of them: What happens when you put 10 economists in a room? You get 11 opinions.

But ask 10 economists if we are heading for a financial crisis like the one in 2008 and some will say “absolutely not.” Others may add caveats about uncertainties and complexities of systems.

Central bankers and others were quick to say that this was not a case of déjà vu and that the crisis of 2008 was not being repeated.

But others said even if this was not a full-blown crisis, there would be consequences, both within the banking system and for the broader global economy as a whole.

Great Recession

Fifteen years ago, there were certainly worries surrounding the financial system. In the first quarter of 2008, much of the developed world was already in what was sometimes called the Great Recession. Some like to refer to the period between 2007 and 2009 as the Lesser Depression or the Great Deflation.

Events were moving towards a climax that would eventually come in the autumn of 2008, but there were already signs of impending doom in the first quarter of that year.

The US housing bubble had burst almost two years previously and one British bank, Northern Rock, had already collapsed in September 2007.

Real estate prices in the US were plunging — by one measure, they were more than 12.5 per cent lower in April 2008 than they were the year before.

Confidence was already starting to leak out of the financial system.

But economists point out that while it may now feel a bit like 2008, it is not.

The conditions that led to the collapse of Silicon Valley Bank this year were very different from what happened in the run-up to the demise of Lehman Brothers in the autumn of 2008.

“When we look at what occurred in 2008, it was brought about by subprime loans, which were endemic across the financial system, which brought the financial system down as a whole,” said William Davies, global chief investment officer at Columbia Threadneedle Investments in London.

“If we look at what occurred in Silicon Valley Bank, it was a bank that had a mismatch of assets and liabilities, which meant that when they got deposit outflows, they had to realise losses from their assets [the bonds they had] which wiped out their equity.”

In 2008, the financial system was exposed to highly risky and toxic mortgage-backed securities, which were sourced from loans that essentially had gone bad.

Last month, Silicon Valley Bank was punished for investing in one of the safest investment instruments around — US Treasuries. The problem there started when SVB saw a massive inflow of cash from a few big depositors a few years earlier.

That money was used to buy US Treasury notes or bonds, which plunged in value as the Federal Reserve increased interest rates at speed over 2022.

The effect was the same as 2008 — confidence started to flee the banking system and especially the likes of SVB.

Crucially though — and this is the major difference between what happened in March 2023 and what happened in September 2008 — the withdrawn deposits from SVB did not leave the system. They simply moved to the bigger banks.

When asked about this difference, Mr Davies told The National: “The run on the deposits there [at SVB] meant that the deposits were growing at the likes of JP Morgan, Citi and the large banks.”

“So, for the sector as a whole, those deposits were still there, although there was an influx into money-market funds (MMFs), but for the sector as a whole, it was nothing like 2008.”

But this could just as easily not have happened at SVB. The bank bought long-dated Treasury bonds with high yields to make the margins worthwhile.

Had the Federal Reserve not increased interest rates so rapidly and by so much, some analysts say SVB might not have floundered. For Guy Foster, chief strategist at RBC Brewin Dolphin, the nature of SVB depositors made for a perfect storm.

“These price falls would have been gradually recouped over the life of the bonds,” he said.

“But unfortunately for SVB, whose customers include many high-spending technology start-ups, the deposits used to buy the bonds were being withdrawn. This forced SVB to sell the bonds, thereby crystallising a loss.”

So, SVB went down, followed by the cryptocurrency-linked bank Signature, and then the Swiss giant Credit Suisse started to wobble as withdrawals rose rapidly.

As with all financial crises, confidence was the key factor. The more central bankers and others shouted “don’t panic!”, the more investors and bank depositors felt uneasy.

But this wasn’t 2008 — there were no mortgage-backed securities, collateralised debt obligations or more nasty surprises waiting round the corner. SVB and Credit Suisse had very individual issues in circumstances specific to each bank.

“Crisis over”, said the central bankers. “There’s nothing more to see. Move along, please.”

“I’m confident that the banks in this country are in a much stronger position [than they were in 2008],” Andrew Bailey, the governor of the Bank of England told the UK Parliament’s Treasury Select Committee last month.

Mr Bailey described the collapse of SVB as “the fastest passage from health to death since Barings”, a reference to the British bank which failed in 1995.

But he said the UK banking sector was “very strong” and that the declines in the share prices of some of the UK’s and Europe’s biggest banks, such as NatWest, were merely down to the markets “testing” their resilience.

But this “testing” is risky in itself — a little like poking a hornets nest. The IMF’s chief economist Pierre-Olivier Gourinchas said this week that significant worsening of financial conditions could recur as nervous investors try to test the “next weakest link” in the financial system, as they did with Credit Suisse.

Federal Reserve Chairman Jerome Powell said the banking system was “sound and resilient,” but did admit that the SVB situation and the knock-on effects on smaller regional banks in the US could send ripples out to slow down the predicted economic recovery.

‘Repercussions for years to come’

While most observers agreed with the central bankers, a lingering doubt remains. After all, central bankers always say the banking system is strong, sound and resilient, don’t they? It would be remiss of them to undermine confidence.

But at least one Wall Street titan was not fully convinced. Jamie Dimon has been chairman and chief executive of JP Morgan since before the 2008 financial crisis.

“As I write this letter, the current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come,” Mr Dimon wrote in his annual letter to JP Morgan shareholders just over a week ago, adding that the risks were “hiding in plain sight.”

The risk to banks that held long-dated bonds in an environment of rapidly increasing interest rates should have been obvious to anyone with a calculator, some observers argue. The question now is, how much of this interest rate-related risk is out there?

“The thing I worry about is interest rate risk,” Ken Kuttner, Professor of Economics at Williams College in Massachusetts, told The National.

“We learnt from SVB that some banks are highly exposed to rising interest rates. The question is, how many other banks around the world have loaded up on long-term bonds?”

“I suspect many of them have in an effort to boost earnings after years of very low short-term interest rates, but I have no idea. Hopefully the regulators are on top of it and have been more proactive about it than they were in the US.”

Mr Dimon was highly critical of the Federal Reserve in his shareholders’ letter, saying it failed to incorporate rocketing interest rates into its annual bank stress tests.

Others said it more than just missteps by regulators — after all, perfect storms need several elements at play.

Mr Powell said SVB’s management “failed badly” in its control of interest rate risk, but added that all Americans, wherever they bank, should now feel that their deposited money is secure.

“What I’m saying is you’ve seen that we have the tools to protect depositors when there is a threat of serious harm to the economy or to the financial system, and we’re prepared to use those tools. I think depositors should assume that their deposits are safe,” he said.

Savings and Loans

If comparisons are to be made, some observers have preferred to make them with a financial crisis 40 years ago, rather than that of 2008.

“A better comparison, therefore, might be to the Savings and Loan Crisis in the US during the 1980s,” Prof Peter Ireland at Boston College told The National.

“Then, as now, the problems were concentrated in smaller banks. The effects on the economy were negative but, by themselves, not enough to cause a severe recession like in 2008.”

Prof Caballero at the Massachusetts Institute of Technology agrees the impact of the collapse is ongoing. “Up to a few weeks ago, the outflow was mostly felt by large banks and was very orderly and consistent with historical parameters,” he said. “That changed in a hurry with the SVB event; we have seen a large reallocation of deposits towards large banks and away from small and medium-sized banks.”

So, while the SVB/Credit Suisse saga may not be a portent of doom, and the prelude to a wider and more serious financial crisis, many economists think it will not be without consequences, the principle of which is a tightening of lending — a credit squeeze.

Many economists argue that the era of low interest rates, quantitative easing and consequentially cheap money in recent years led directly to the inflationary problems in the developed and developing world today.

They also contend that the tardiness on the part of the central banks, the Federal Reserve in particular, in tackling inflation when it first reared its head led to the rapid rises in interest rates over 2022, which in itself was a destabilising factor.

Dr El-Erian at Cambridge University told The National that this policy episode will “go down in history as one of the biggest Fed policy mistakes.”

What next?

Most economists argue that while the recent banking crisis was serious, it did not pose a systemic risk to the financial system in the same way the subprime problem did in 2007-2008.

But confidence has been dented once again, and worries persist that something else could be lurking out there. At best, the whole episode has lengthened the period of predicted economic recovery.

In its latest World Economic Outlook report the IMF contends that banking system contagion risks were contained by strong policy actions by central banks and others in the wake of SVB, Signature and Credit Suisse.

But the IMF added that the whole saga has meant the “fog around the world economic outlook has thickened.”

In what the IMF called a “plausible scenario”, it predicted that the fallout from the banking crisis could mean that banks across the board tighten up on their lending and shore up their capital.

In this scenario, “funding conditions for all banks tighten, due to greater concern for bank solvency and potential exposures across the financial system,” the IMF said.

According to the IMF, this “moderate tightening” of financial conditions could slice 0.3 per cent off global growth this year, cutting it to 2.5 per cent.

Prof Ireland at Boston College told The National that “because tighter monetary and fiscal policies will surely persist into 2024, and since problems with the banking system are likely to take time to fully repair, I do think that, at the very best, we’re in for a couple years of sluggish growth, if not outright recession.”

“The best-case scenario would be a growth slowdown this year and next, followed by a return to more robust growth in 2025,” he added.

Dr El-Erian at Cambridge University believes that, fortunately, the worse of the financial contagion is behind us.

“Unfortunately,” he told The National, “this cannot be said of the slower-moving economic contagion.

“It reflected the coming together of three factors: First, poor risk management on the part of the banks,” he said. “Second, a mishandled interest rate cycle by the Federal Reserve. And third, lapses in supervision.

“All this demonstrated that systemic risk need not come just from the largest banks. Smaller ones can also pose a threat under these conditions.”

What the woes of SVB and Credit Suisse have shown is just how vulnerable the system can be to shocks, both internal and external.

For example, SVB would not have collapsed at the speed it did in 2008. The reason for that is what built the bank in the first place — technology.

In 2007, it was clear that confidence was ebbing away at Northern Rock as lines of depositors wanting to withdraw their money snaked out of branches and down Britain’s high streets.

However, in the case of SVB last month, depositors got their information on social media and withdrew their money with a few clicks on a laptop or mobile phone.

Nonetheless, while the banking system is not out of the woods yet, the consensus among most economists is that a full-blown financial crisis is not likely in the near future.

“So far there hasn’t been much contagion from the SVB failure, so hopefully the financial instability risk has been contained; and the energy shock seems to have been managed in Europe,” Prof Kuttner at Williams College told The National.

“There’s always the possibility of an unforeseen shock, of course, but the major economies have already survived a couple of big ones.”

Meanwhile, Richard Hunter, head of markets at Interactive Investor, told The National that confidence was “slow to build and quick to shatter.”

“While there is little question that UK banks are in good shape, particularly compared to the markedly different events leading up to the great financial crisis [of 2008], any further shocks within the sector would be heavily punished,” he added.

But knowing where those further shocks will come from is the trick.

When visiting London back in 2017, Janet Yellen — now US Treasury Secretary, but at the time head of the Federal Reserve — was asked if we would see a financial crisis on the scale of 2008 ever again.

“You know probably that would be going too far, but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be,” she said.

The speed and complexity of financial systems are a tremendous asset in good times, but can work against the system itself when problems emerge. The more complex any system becomes, the trickier it is to regulate.

“I just don’t think regulators are capable of monitoring big financial institutions in a way that makes them invulnerable to losses,” Prof Ireland told The National.

“The institutions are too complex, it’s too easy to hide risk, and there may be conflicts of interest, too, as deep-pocketed banks too easily provide incentives for regulatory forbearance.”

Not can only can risk be hidden, but financial crises are, by nature, unpredictable, according to Prof Caballero at MIT.

“Financial crises are very non-linear events, so what looks reasonably under control now can deteriorate in a hurry,” he told The National.

“We live in very uncertain times.”