With Credit Suisse and First Republic Bank needing bailing out of a seriously sticky situation and Silicon Valley Bank (SVB) completely collapsed, it’s been a tough start to 2023.
The most common cause of bank failure is when the value of the bank’s assets falls to below the market value of the bank’s liabilities – the bank’s obligations to creditors and depositors – and this scenario can occur if the bank loses too much on its investments.
What happened with SVB?
The bank had a high proportion of uninsured deposits and a large proportion of deposits invested in hold-to-maturity securities.
Their client base was small to medium US tech-based businesses and when some investors decided they wanted their money out, the tidal wave of like-minded investors that followed created an imbalance that couldn’t be overcome – a mismatch between short-term deposit requirements and long-term dated bonds.
Interest rates had soared to such a level that bonds had dropped like a stone and there simply wasn’t enough in the SVB pot to cover the capital depositors were asking for.
Why were depositors scrambling to get their cash out?
For small to medium tech businesses in the US it hasn’t been plain sailing over the last 12 to 18 months. The insurance limit on US depositors was $250,000 but some had deposits over that amount and concern set in as to whether they’d be able to get their money out. Once a few depositors got spooked, it didn’t take long for panic to set in and for the snowball effect to gather momentum.
The collapse of SVB sent shockwaves through financial and tech circles. Was it an isolated incident caused by a specific vulnerability and set of circumstances, or is it the start of the new direction of travel? The shutting down of Signature Bank by federal regulators due to concern around depositors withdrawing large sums of money and the fear of continued contagion would seem to support the latter.
What about other financial institutions?
First Republic Bank have had to rely on an injection of $30 billion from a consortium of 11 major US banks to resolve liquidity issues and the government has stepped in with a wider goal of stopping the zero-confidence rot spreading to global markets and then came the Credit Suisse event…
Credit Suisse hasn’t been favored by investors for some time now.
This vibe intensified when the bank postponed the publication of their accounts. When the report did come out, it highlighted material weakness in internal controls in relation to financial reporting and risk assessment.
The Saudi National Bank, who bought a 10% stake in Credit Suisse in 2022, couldn’t provide any additional support so the Swiss National Bank stepped in with emergency credit to the tune of CHF 50 billion, but even that wasn’t enough to stop the inevitable flurry of negative sentiment from investors.
UBS finally bought Credit Suisse for $3.2 billion; the understated value of the transaction reflected the issues within the Credit Suisse business. As part of the deal, UBS were provided with their own liquidity facility of CHF 100 billion and downside protection of CHF 25 billion against any future losses on the purchase.
A decent deal for UBS which bailed Credit Suisse out of an unenviable position between a rock and a hard place.
What does investing with Environmental, Social, Governance mean
Read the Bank of England statement on the bank rate increase to 4.25%
What happened next?
The Swiss government rewrote legislation to allow the transfer to take place, but this change then caused the value of AT1 (Additional Tier) bonds, which typically sit below equity in the capital structure, to plummet. The investor reaction was confusion and the ramifications of the actions of the Swiss authorities may well have consequences for bank debt markets for years to come.
So where are we now and what’s the general feeling?
Basically, a profound negative sentiment towards US small and mid-cap banks.
The bigger banks have come out relatively unscathed with depositors choosing to move their cash into perceived ‘safer havens’, but the damage to the reputation of the banking system across the world appears to have been done. The value of shares and bonds has dropped for European financials, the insurance sector has been hit in the aftermath and the banking system has taken on an air of fragility.
What impact has the change in legislation by the Swiss regulator had?
A shocking movement in the goal posts has left investors with a bad feeling towards the banking sector and they’re likely taking a step back to absorb the shift and to ask themselves how this affects the sector as an investible concept going forward. Should they invest in AT1 bonds because the level of assumed protection may no longer be there?
What’s the future likely to hold?
The expectation is that banks will start to tighten their lending standards and credit allocation, making it more difficult for people to borrow, which will cause less demand for credit and represents a tightening of financial conditions.
The knock-on effect is that central banks may not need to act to the extent anticipated. In this context, there may be less interest rate rises and cuts could be brought forward causing some long-term fixed income markets to outperform.
It was anticipated that the Bank of England would raise interest rates by 0.5% in March, but both the Fed and the Bank of England put rates up by 0.25% – recognition that there’s weakness in the financial sector; they need to get inflation down, but they can’t tighten too much due to the natural tightening that’s likely to come.
Before recent events, it was hard to imagine that interest rates would come down anytime soon but now there’s talk that we may even see rate cuts by the end of 2023.
What does all this mean for investors?
There’s been a general shift back into quality growth equities as they are less interest rate sensitive but re-adding interest rate risk into portfolios may also make sense as they may make a comeback sooner than expected if interest rates peak earlier – some fund managers are already moving in this direction.
The shift in sentiment may calm down in the coming weeks and months or it may be here to stay – it’s impossible to say how badly investor confidence has been damaged by recent shocking events. In a few months’ time it might all start to feel like a distant memory, or the new vibe may become hardwired.
