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A recap on Silicon Valley Bank (SVB).
The reality of US rate hikes and the fact a period of 13 years of lax monetary policy ended has faced plenty of doubters. Some believed the Fed would ‘pivot’ back to near zero interest rates quickly, convenient thinking, as it would cut bond losses. One doubter was SVB who retained its bonds and warehoused losses, creating a funding mismatch and structural weakness in its balance sheet.
During the C-19 pandemic, SVB’s clients in the US tech sector hired staff quickly. Many techs over-hired and payrolls have eroded margins and cash balances. Hence tech co’s cash expenses rose sharply increasing their cash drawdowns at a time when fund raising efforts (i.e. income) was hurt by the tech bear market. SVB was facing increased deposit flight. The higher rate environment has also led to more competition and depositors shopping around for better rates than bank deposit accounts that pay sub 1%.
SVB launched a $2.5bn sale of common and preference stock, but it became clear that given the bad news and deposit pressure, US investors were not interested in plugging its balance sheet hole. Last Thursday top US venture capital firms were advising clients to withdraw their cash from SVB. This was critical to an institution with over 50% deposits from tech/ VC entities. The deposit flight from SVB by some measures the fastest ever.
That Thursday evening, the bank’s website stopped allowing deposit withdrawals and shut down. In online chat rooms, there was talk of an ‘IT glitch’. When regulators moved in on Friday morning it became clear SVB could not fund deposit withdrawals and could no longer undertake normal banking operations. Regulators closed SVB around midday, not after the close of business.
Given the speed and magnitude of the deposit leakage, there was no time for rescue fund raisings, Fed windows, asset sales, corporate ‘white knights’. The collapse of SVB was inevitable given its circumstances, the context and 48 hours timeframe.
The worry is not so much systemic risk, i.e. the safety of the US banking system, or the threat to smaller ‘community banks’, it is the fact that banks have lost on their bond holdings. There is speculation as to how affordable these losses are.
According to the FDIC chair Martin Gruenberg at the Institute of International Bankers on the 6th March 2023 the Fed hike cycle has caused c. US$620bn of losses on holdings of US Treasuries and other high grade bonds.
How is this treated? According to IFRS accounting rules, an important distinction must be drawn between two forms of asset ownership.
The problem for SVB was the minute their US Treasury bonds were up for sale i.e. AFS, their losses became real deductions from capital.
SVB held a $21.4bn portfolio of US Treasury and mortgage backed bonds on AFS but when the bonds were sold in one block to Goldman Sachs, it triggered a $1.8bn loss. On its remaining $91bn bonds it was sitting on a $15bn loss if those bonds were treated as AFS. This loss equated almost SVB’s entire tangible capital of $16bn.
Other global banks may well hold significant losses but these will not be recognized until the bonds are up for sale. Bank of America for example has disclosed $632bn of HTM bonds which if valued on an AFS basis would trigger a loss of $109bn. But Bank of America also has $1.9trn of retail deposits (on which depositors earn a princely rate of 0.01%) whilst the bank earns the market interest rate currently 4.75%.
Unlike SVB, Credit Suisse (CS) problems, poor risk management, ongoing losses are well known and understood. In 2021 CS lost CHF 1.57bn after exceptional litigation provisions of CHF1.1bn and losses of around US$5bn relating to Archegos collapse. A subsequent internal report on counterparty risk exposures noted that CS made just $17.5m in fees from Archegos in 2019 but was exposed to c. US$20bn losses if Archegos failed. CS risk management had failed following a loss of key risk management staff. In 2022 CS losses had increased to CHF 3.3bn. The investment banking division revenues dropped from CHF 9.9bn to CHF4.6bn in 2022 and lost CHF3.1bn in part due to restructuring charges.
Switzerland’s rather lax banking supervision, FINMA, has moved only very slowly to address problems at Credit Suisse.
CS plans to exit US investment banking via the sale of CS First Boston. Last October new CEO Ulrich Koerner promised to simplify CS via a 3 year transformation plan and raised fresh funding via a rights issue. The plan was to cut 9,000 jobs up to 2025 taking out CHF2.5bn of expense.
On Tuesday Credit Suisse shares came under pressure after the chairman of Saudi National Bank, said his bank could not increase his ownership above 10% due to regulatory constraints. The Saudis had been the cornerstone investor in October’s CHF4bn fund raise. It had been wrongly assumed that Saudi National Bank was potentially a white knight for CS that would whisk away shareholders from the pain of heavy losses.
There has also been issues as to statements from CS about the outflows from CS. In 2022 CS had €97bn in total outflows of that €93bn occurred in Q4 – about 60% of the outflows were deposits. There have been suggestions that CS were not accurate last October on the outflow issue.
When coupled with the previous day’s disclosure by its accountants of ‘material weakness’ in reporting and an adverse opinion in ‘internal controls’ the stage was set for a broad reassessment of CS risk. This was especially true after a Bloomberg interview with the CS CEO who seemed a bit puzzled and in denial about the market’s response.
Major EU banks have started cutting counterparty risk exposure, this is maximum level of interbank lending permitted between one banking institution and another. When counterparty exposure is cut, the bank becomes more reliant on central bank funding and depositors.
Credit Suisse’s October fund raising / restructuring plan was intended to buy time to complete its transformation plan. However CS is only expected to become profitable in H2 2024. If depositors continue to withdraw their funds, it may not have sufficient time to reach profits. A deposit run reduces net interest income immediately and cuts into net interest margin as it deprives the bank of a cheap source of credit replacing it with higher costs of credit.
Furthermore as other banks who have downsized have demonstrated, cutting staff and/or selling off major chunks of the banks means cutting revenues profits, permanently damaging the franchise. As CS has already seen the loss of key personnel often means the bank is losing professionalism and reputation. The CS transformation plan does not have a lot of credibility frankly.
The Swiss National Bank move to calm fears and stand behind CS with a US$53.7bn credit line should reassure both depositors and counterparties. The Swiss authorities have decided taxpayer support in the form of the central bank will have to be provided. CS is ‘too big to fail’, SVB was not, that is the likely crude reality of it. But the CS problem of heavy ongoing losses does not go away.
First point is a bank failure is bad regardless – the depositors are usually saved but the bank’s shareholders lose their investment and bondholders might only get partial repayments. But is it correct to say the banks are in 2008 having learnt nothing? No.
CET1 ratios (broadly capital levels) are far higher than in 2008, in most cases three to four times higher. In 2008 banks typically had capital levels below 4%. A high capital ratio when coupled with central bank support and the political will to provide support has kept ailing institutions alive whilst problems are solved. The Japanese banking system in the 90s is one example.
Second point, regardless of the date, a run on deposits can hit any bank at any time and can quickly turn a bad situation into one that is highly unstable. That is why banks are loathe to come clean about problems, unless everyone else is coming clean about the same problem. Depositor flight is always a risk for any bank, and more of a risk for smaller ones.
The stars were aligned in the last fortnight for a problem to snowball. In the social media age, time is of the essence and companies have to move quickly to address problems head on. SVB did not have the time or support to be rescued. We do not expect CS to fail as its problems are fixable, though it will take time to get them fixed. At its heart, I suppose is the fact that Switzerland can afford to save CS.
Financial ‘contagion’ as in the Asian crisis, the 2008 crisis and in 2011 is at its heart a summation of fears and worries that can be partially explained by volatility, basically institutions being caught offside when policy changes or economic shocks occur. In the last year, cheap money has gone. That was bound to expose financial institutions to new pressures and challenges. Looking forward now, there is likely to be tougher oversight but also a more cautious approach to further interest rate hikes.
The “too big to fail” issue is still a reality for the largest banks.