The events over the past week bear an eerie resemblance to those of the 2008-9 Global Financial Crisis (GFC). Banks have failed, rumours swirl about the next victim and investors hold weekend vigils awaiting the next alphabet soup solution from banking authorities. So should we be concerned? Is there good reason to think that we are on the cusp of a major financial crisis, and should depositors fear the safety of their money?
The GFC sparked significant changes in the regulation of banks across developed markets to shore up the banking system and increase confidence. Banking regulation is an incredibly complex subject with differences across regions. However, the thrust of the regulation has delivered two key changes to banks over the past decade:
- Banks are significantly better capitalised. Put simply, this means that they are holding more money as a protective buffer for depositors should they see a deterioration in the ability of borrowers to repay their loans to the bank. In a recessionary environment the likelihood of bad debts increases, an increased capital buffer and stringent stress testing ensures that banks can weather the worst of storms in this regard.
- The quality of banks loan books have significantly improved. This means that banks have become a lot more discerning when deciding who (and how much) to lend their money to. A much larger portion of the loan books (banks assets) are comprised of higher quality assets such as government bonds. Banks are also required to hold significant portions of cash, held with Central Banks. Furthermore, their government bond holdings are also highly liquid, meaning they can be easily converted to cash to fund outflows.
Therefore, depositors should be more confident that the banking system is safe from risks stemming from a deterioration in the quality of the banks assets. Banks liquidity situations are much improved and bank solvency is very unlikely to be an issue.
But the collapse of Silicon Valley Bank (SVB) highlights that despite these measures, banks can still fail. In fact, the collapse of SVB was partly because their assets were largely comprised of very high-quality assets in the form of US government bonds. Unfortunately, they had purchased these bonds over the past few years when interest rates were low and bond prices high. The bank had in effect bought long dated bonds and funded that with short dated deposits. When some of their depositors needed their money back, the bank was forced to sell some of these bond assets and realise a loss on their investment*. Is this a systemic problem and could other larger banks fail for the same reason? Again, there are reasons to think not:
- SVB was particularly at risk given a high concentration of depositors (few retail deposits, low geographic diversity and a small number of large deposits from technology companies) and assets that had a high degree of sensitivity to rising interest rates. Other large banks have much more diversified deposit bases (less likely to leave all at once) and their assets have lower sensitivity to changes in interest rates.
- Regulators have acted quickly to solve the liquidity risks. The majority of banks will hold sufficient cash to meet redemptions. But to prevent other banks from the extreme scenario of having to sell assets to meet deposit redemptions, the Federal Reserve created a program to lend the banks money (on fairly generous terms) to meet those redemptions. This program was created and up and running within days of the SVB collapse, illustrating that regulators have become adept at identifying and stemming the risks should they arise.
After a major bank collapse, inevitably investors are on the alert for the next potential victim. Credit Suisse has had its fair share of travails over the past few years and so confidence in the bank was already low. But here too, authorities have been quick to act to ensure that the bank is not a victim of a liquidity crisis. The Swiss Central Bank has provided CHF50bn in loans to the bank to ensure that the banks depositors can be confident they can maintain access to their money.
All of this is to point out that the banking system as a whole is much more robust than a decade ago. Depositors should be much more confident that their money is safe in banks and the risk of another GFC is extremely low. In many respects, the SVB collapse has illustrated that the regulations and process to protect depositors have worked. All depositors in the failed banks were given access to their deposits on the Monday following the Friday collapse. But whilst depositors have not lost a cent, shareholders have borne the loss of their investment, illustrating that investments in banks still carries risks.
*It’s worth noting that if the depositors didn’t require their money bank and simply left them in the bank, the bank’s assets would have appreciated in value over time and the bank would have likely remained profitable. This was not an issue of profitability but one of risk of liquidity, i.e. deposit flight.