What Next?

by | March 20, 2023

One of the few advantages of being over 60 is the experience of having seen many financial crises unfold in real time. From my prior vantage points in graduate school, banking, investment banking, and asset management, I have had a front-row seat at every financial crisis from the failure of Continental Illinois Bank in 1984 to the collapse of Silicon Valley Bank this past week.

In what follows, I draw on my experience to offer conclusions—some tentative and others firm—about what is happening today.

Experience suggests that when the financial system is in stress, surprises are in store. Large and small institutions can get into trouble when you least expect it. Stresses can spread in unanticipated directions. Postmortems uncover connections hidden in real time.

The first conclusion is therefore a modest one: We should acknowledge how little we know, be wary of quick conclusions, and be hesitant to forecast what comes next. For every pundit who claimed he or she ‘saw it coming’, most so-called experts are humbled (or ought to be) by our inability to predict when financial dislocations will occur and how they may evolve.

Financial crises come in many shapes. They may trace their origins to stock market euphoria (1987, 2001), bear markets in bonds (1994-1995), irresponsible foreign lending (various emerging market crises in the 1980s and 1990s), asset price mania (global financial crisis), commodity price shocks (Continental Illinois), and external imbalances (Eurozone financial crisis), among others.

When banks get into trouble, as is now the case, the focus narrows to the asset and liability sides of their balance sheets. Either or both can lead to panics, runs and failures, which can then spread to stock and bond markets and the broader economy.

Bank failures can be idiosyncratic, linked to poor management at a handful of banks, or systemic, stemming from similar risk factors shared by all banks.

Banks can become insolvent, meaning that the value of their assets has fallen sufficiently to wipe out their capital. Or they can become illiquid as depositors rapidly withdraw more cash than banks hold reserves.

At first glance, the current stresses appear to be idiosyncratic—the fault of individual bank management. Silicon Valley Bank had a narrow and undiversified deposit base, making it more prone to liability runs than other banks. It also had insufficient risk management, above all in hedging against losses linked to rising interest rates in its holdings of Treasury bonds and mortgage-backed securities. Similarly, Credit Suisse has been beset with years of scandals in its asset and wealth management units, as well as accidents in its investment banking operations.

But logic suggests other factors are at work. If the problem were only in a few banks, the rescue measures taken over the past week to assure depositors, shut down banks (SVB, Signature) and provide funding (Credit Suisse, First Republic) should have contained the crisis. Yet stresses remain, evident in plunging bank share prices and rising costs of default protection in the sector.

The common risk factor is rising interest rates. Following more than a decade of super low interest rates worldwide, a surge of inflation starting in 2021 brought a sudden change of global monetary conditions, with the Federal Reserve and other major central banks hiking interest rates in greater unison and more rapidly than at any time in more than a generation.

The abrupt shift in global monetary policy has had significant impacts on banks’ operations, including:

  • Increasing pressure on deposits, with banks now having to compete for funds against higher interest rates offered by money market funds.
  • Increasing risk of losses on assets, given that banks are large holders of government bonds, mortgaged-backed and other securities whose prices have fallen as long-term interest rates have risen.
  • Increasing pressures on profit margins resulting from the fact that in many countries (Japan the notable exception) short-term interest rates have risen relative to long-term interest rates, which tends to increase bank funding costs relative to their revenues derived from longer-maturity lending and asset holdings.

At the very least, rising costs of borrowed funds relative to returns on assets weakens bank profitability and depress the industry’s equity valuations. In extremis, deposit outflows to higher yielding securities can force banks to sell assets at a loss, resulting in concerns about capital adequacy and solvency, as was the case for Silicon Valley Bank.

Accordingly, it is premature to conclude that the rot will stop at SVB and Credit Suisse. Other banks may wobble. Reports that US banks may have drawn last week on the Fed’s discount window, the Federal Home Loan Bank, and the newly created credit facilities established by the FDIC to the tune of close to $500bn indicate that, at the very least, banks other than those in the headlines may be shoring up their liquidity in preparation for more stress to come.

In short, it remains premature to conclude that the crisis has been contained.

Still, we can draw a few conclusions from the current episode.

First, banks always have been (and will remain) risky enterprises. Fractional reserve banking—the practice of holding only a small fraction of deposits in reserve and lending out the rest—works well until it doesn’t. When depositors become nervous about a bank’s health, the outcome is a rush to withdraw, which can bring the bank down, as we saw in the case of Silicon Valley Bank.

Second, banks are interdependent. Partly, that is because they share a common payments system and in turn have obligations with one another. But fundamentally, the greatest source of interdependent risk is perception. If one bank wobbles, depositors at others may rush for their cash. In a crisis, acting before asking is the logical response when reserves are insufficient to cover deposits.

Third, banks embed asymmetric information. Managers know more than depositors do about the lending risks they have taken. Depositors know that managers have superior information, which means they become skittish at the first signs of trouble.

First principles of economics teach us that competitive markets will fail if actors are not independent and if all pertinent information is not fully shared among all parties. Banking has never been and will never be a place where free markets work. Market failure is inherent to banking.

That is why regulation is required. To prevent bank runs, deposit insurance and the central bank lender of last resort functions (the ‘discount window’) were established. But if governments and central banks are to assume liability risks of commercial banks, taxpayers must demand adequate supervision and regulation of bank management.

Appropriate supervision and regulation were absent in the case of Silicon Valley Bank, which after Congress and the Trump Administration amended US legislation in 2018 was not subject to sufficient oversight, including stress testing.

Yet as onerous as supervision and regulation may be, America’s small- and medium-sized banks ought to welcome it. The irony is that they are now prone to regulatory arbitrage as nervous depositors shift their funds to systemically important banks (SIBs). Those are America’s banking behemoths, which are seen as safer because their size commands more regulation and supervision as required of institutions ‘too big to fail’.

Yet as much as increased supervision and regulation seem the most logical outcome of this latest banking crisis, divided government could thwart progress in enacting appropriate legislation.

Finally, one other outcome may one day emerge, if not from today’s banking crisis, then from its inevitable successor, namely a separation of the payments system from lending.

Banks serve many purposes, but a key one is enabling individuals and companies to pay one another. But in the current system, the payments system is put at risk every time the banking system convulses.

Payments are also a public good, with benefits flowing to all who use it, whether they pay for it or not. Here, too, first principles of economics tell us that free markets will under-supply a payments system that is not otherwise linked to the profit-making enterprise of banking, namely lending.

But ordinary citizens and many businesses are growing tired of having to be creditors to risky lenders in exchange for the safekeeping of their cash and their ability to pay one another. Isn’t there another way?

There may be—called central bank digital currency or CBDC. In theory and perhaps before long in practice, central banks could assume responsibility for the payments system via the distribution of central bank digital currencies, with settlement via the blockchain or other secure systems.

Banks as payment vectors would disappear. Lending would then be undertaken by financial entities that raise funds in capital markets, rather than from ordinary depositors. The risk of lending to those entities (we cannot call them banks because they don’t accept deposits) would then be transferred to those willing and better able to take and manage it.

And what we call depositors today, namely individuals and businesses primarily interested in safekeeping their money and making payments, would be served by CBDC.

The other option, of course, is to turn all banks into heavily regulated entities, akin to public utilities. In that case, bankers ought to have their big salaries slashed. After all, why should a bonus culture exist in a regulated utility?

But as good as that might sound to those prepared to take up pitchforks in the cause against those dressed in pinstripes, it is worth noting a simple truth about utilities. Generally, we dislike them, because all-too-often they are the sole provider of an inferior service. Is that what we also want from our banks?

Banking crises are nothing if not attention grabbing. But maybe, this time, they should also turn our attention to alternatives to banks.

Filed Under: Economics . Featured . Politics

About the Author

Larry Hatheway has over 25 years’ experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, a non-profit offering commentary and analysis on the global economy, matters of public policy, and capital markets. Larry is also the founder of HarborAdvisors, LLC, an investment advisory firm catering to family offices and institutional clients worldwide.

Previously, Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making, and multi-asset investment strategy.

From 1992 until 2015 Larry worked at UBS Investment Bank as Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). Larry is widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN, and other media outlets. He frequently publishes articles and opinion pieces for Bloomberg, Barron’s, and Project Syndicate, among others.

Larry holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and resides with his wife in Redding, CT, alongside their dog, chickens, bees, and a few ‘loaner’ sheep and goats.

Related Posts

Pin It on Pinterest

Share This