A tale of four banks
Market volatility increased during March as fears of another GFC style banking crisis reverberated across global financial markets. The trigger was the fallout from the Silicon Valley Bank (SVB) bankruptcy, a second tier but relatively large regional bank in California. Other regional banks in the US have also entered bankruptcy (Silvergate and Signature Banks). Importantly, the insolvency of one of Europe’s largest banks, Credit Suisse, raised major concerns that there are similar risks embedded across the global banking sector.
The problems with some of the US regional banks stemmed from a lack of diversification in their deposit/customer base and weak regulatory oversight of smaller banks. SVB, Silvergate and Signature banks experienced significant growth from a booming tech/crypto sector. Most of these deposits were well above the $250,000 federal deposit insurance limit, so when large uninsured depositors caught wind of potential problems, coupled with social media, a classic ‘bank run’ ensued. US regulators acted quickly to guarantee all deposits with these institutions and introduced a new lending programme that is expected to help stabilise conditions.
Credit Suisse on the other hand, had problems simmering for several years with the bank’s leadership not being able to recover from the high-profile problems associated with its lending divisions and other scandals. The Swiss regulator, FINMA, orchestrated UBS to buy Credit Suisse at a significant discount to market value to curtail the risk of potential contagion and preserve financial stability. Controversially, Swiss regulators also chose to exercise a unique bond clause that caused Credit Suisse’s US$17 billion Additional Tier 1 Capital (‘AT1’) Hybrid securities (also known as ‘convertible preference shares’ or ‘CoCos’ or ‘hybrids’) to be written to zero. That is, bondholders took the loss before equity holders, which went against most legal precedent and investor expectations. Such securities were introduced after the GFC to enable both bond and equity holders to absorb losses, rather than the public by way of bailouts. These types of bonds have also been issued by many other European banks and the news of the Swiss regulator’s actions created more stress in markets. UK and European regulators quickly distanced themselves from the Swiss decision and confirmed that these types of securities would not suffer a default ahead of equity, which is normal practice. Although the contagion effect cannot be eliminated in the short run, Australian authorities confirmed the strength of our banking sector. Global financial markets now appear to be in the process of stabilising.
The Credit Suisse and US regional banking problems have arisen from quite separate issues, the common outcome however, has been a loss of investor confidence resulting in large depositor withdrawals creating liquidity/solvency issues. A loss of confidence can cause a ‘bank deposit run’ but Central bank actions can prevent conditions from deteriorating. The US central bank also has various international liquidity facilities that help other central banks gain access to USD funding when there are global liquidity strains. These were initially established in the GFC and have been at play in recent days. Although events are still fluid, the investment lessons seem clear. Diversification remains a common-sense principal both in terms of running businesses such as banks and for investors building diversified portfolios.
Central banks playbook – balancing inflation risk and financial stability
US fixed interest markets reacted violently, with short-term government bond yields falling from 5% to 4%, in a matter of days, as speculative bets for higher interest rates were unwound. The key question is whether Central banks can continue to raise interest rates to slow inflation but provide enough liquidity support to maintain financial stability. These somewhat contradictory policy choices are analogous to modern cars Anti-lock Braking Systems (ABS) that enable a driver to brake hard (raise interest rates) but continue steering to avoid a crash. Recent events demonstrate policymakers have ‘ABS’ like tools at their disposal, but like driving a car, taking the foot off the brakes is necessary at times to allow better steering to avoid major obstacles.
In their 22 March meeting, the US Federal Reserve increased rates by 0.25% from an earlier expectation of 0.5%. Market pricing, however, is now implying rates are likely to be cut during the second half of the year.
What does this mean for fixed income strategies?
The exposure to Credit Suisse AT1 securities is relatively small for a number of the core fixed income managers rated by Lonsec and losses appear well contained. A number of specialised credit managers which have sizeable exposures to AT1/CoCos as part of their mandate have experienced drawdowns. As part of their toolkits, managers are using active duration positioning and credit and tail risk hedges to partially insulate the portfolio during risk-off market environments. Australian investors, direct exposures to US regional banks and Credit Suisse are relatively minor with these banks equity exposures less than 1% of the MSCI World Equity Index.
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