BANKING SECTOR DISTRESS
Only a couple of weeks after the anniversary of the start of Russia’s all-out war against Ukraine (February 24), another shock started to unfold for the global economy: increasing banking distress in the United States and its contagion effects. The events surrounding the collapse of three U.S. banks brought back memories of the Global Financial Crisis of 2007-8. The case of Silicon Valley Bank motivated the U.S. authorities to take bold action to tackle any systemic risks proactively.
Nevertheless, the current market turbulence cannot be compared with that of 16 years ago. Banks today are in much better shape in terms of capital and liquidity on both sides of the Atlantic than back then. Regulation is well advanced, and fallback and liability solutions or resolution mechanisms ensure the most controlled and coordinated approach to failing institutions. In addition, a significant paradigm shift has occurred since the fall of Lehman Brothers (September 15, 2008), characterized by an interventionist policy. A case like Credit Suisse, like a carelessly discarded cigarette in the forest, can quickly develop into a conflagration if hesitant action is taken; supervisory authorities would rather ensure that the situation calms down as soon as possible by taking bold action.
Credit Suisse always fulfilled the special regulations applicable to systemically relevant banks regarding capital ratios and liquidity requirements. When investors’ and depositors’ suspicions about the health of the bank first emerged, Swiss authorities provided CHF 50 billion to Credit Suisse. This was intended to dispel doubts about the liquidity situation and prevent the turbulence from spreading to other market participants.
A core problem of the turmoil was the bond portfolios, which came under pressure during aggressive monetary policy normalization and have thus become “underwater” in the banks’ books. Although their price losses do not have to be recorded in the results in the case of “hold to maturity,” a necessary freeing up of liquidity in the case of a massive withdrawal of customer deposits may make it necessary to uncover these losses. The Swiss authorities aimed to break a negative spiral, restore confidence in the institution or the markets, and prevent a possible domino effect from the outset.
However, the creeping loss of confidence at Credit Suisse had been going on for some time. This has resulted from years of corporate restructuring measures, during which the bank was more concerned with itself, which led to an exodus of employees, and an unclear strategy concerning the investment banking division, which is already weakening due to the Russo-Ukraine war and a lack of deals. Poor internal control systems also led to the CHF 4.4 billion debacle regarding the bankruptcy of the U.S. hedge fund Archegos Capital in 2021. In the previous year, Credit Suisse posted a loss of CHF 7.3 bln and reported an outflow of client funds worth CHF 111 bln in the final quarter of 2022 alone.
Eventually, as an emergency solution, Credit Suisse was taken over by rival Swiss bank UBS. The transaction aimed to halt the ongoing loss of confidence and prevent serious negative consequences with unforeseeable
THE MACROSCOPE REPORT
1
THE MACROSCOPE REPORT HUNGARIAN ECONOMIC OVERVIEW
Q2 2023
repercussions not just for the Swiss financial market but also for its global peers. The takeover price was far below the last traded value of Credit Suisse by market capitalization.
As a consequence of the deal, Credit Suisse’s subordinated AT1 bonds, with a volume of around CHF 16 bln, became worthless.
Since both institutions belong to the group of 30 globally systemically important banks, the events received significant international attention. In an initial reaction, U.S. Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell, for example, welcomed the solution. The chairman of the board of directors of Credit Suisse, Axel Lehmann, described the merger as the “best possible outcome.”
One of the monetary policy consequences of the banking distress is the tightening of credit conditions. The Federal Open Market Committee (FOMC) decided to raise the target range of the federal funds rate by 25 basis points to 4.75-5% at its March monetary policy meeting (March 21-22). The Federal Reserve found a compromise between ongoing inflation risks and a banking sector in turmoil by hiking the policy rate by 25 basis points. The guidance for continued rate hikes was softened significantly, such that the terminal point is in plain sight. Should financial conditions have failed to stabilize, this could have been the end of the Fed’s hiking cycle.
On the banking sector, Powell was not ringing any alarm bells, and the FOMC stated: “The US banking system is sound and resilient.” The turmoil in the banking sector is seen as being based on idiosyncratic factors related to inadequate risk management practices in individual banks, which requires investigations in regulatory processes. Nevertheless, determined action by the Fed and the U.S. Treasury was necessary to limit contagion to the banking sector as a whole.
The European Central Bank has positioned itself similarly to the U.S. Fed. Financial market conditions are as important a factor for the further interest rate path as economic data. However, the “liquidity stress” in the euro area is lower due to certain conditions, including bank regulation, deposit insurance, and monetary policy instruments. Moreover, key interest rates are far below the U.S. level. As the underlying inflationary pressures (the core rate) are incompatible with the central bank target, council members are pushing for further rate hikes. On the interest rate market, the message from ECB council members has been partially taken on board, and after the slump of interest rate expectations, at least another hike of 25 bp has been priced in again.
It is clear that the accumulation of “individual cases” from the banking sector in the last few weeks has created uncertainty, and some investors are asking whether these are a symptom of a more significant problem since, historically, an overstretch in monetary policy tightening has often meant the end of an economic upswing.
While the risks of this cannot be entirely dismissed, it is more probable that this is not currently the case. On the positive side, the authorities in both the United States and Switzerland reacted very quickly and quite comprehensively to the problems. The measures taken can be seen as sufficient to calm the market and contain the systemic risks.
That does not mean, however, that other individual cases cannot arise and cause unrest. Nevertheless, the market has gradually adopted the view that the responsible agents are prepared to intervene with support
2
