Deposit linked insurance scheme

The problems of the financial system today are perhaps best summarised by the title of the Oscar-winning film “Everything Everywhere All at Once”.

Lots of noise, lots of small explosions, lots of confusion and idiosyncratic episodes happening throughout the developed world, which seem to amount to a chaotic mess.

To top it off, some of the rescue efforts from authorities have caused nearly as much confusion and consternation as the bank implosions they are seeking to resolve.

Stack that on top of the inherent complexity of finance and you might be left wondering: what on earth is going on?

Well here is a five-stop tour through the banking panic of 2023 – or rather, where the banking panic of 2023 stands as of 20 March.

Interest rates

1. Let’s begin with interest rates, since they are probably the simplest common factor behind much of what’s currently going on.

As you’ll probably have noticed, they’re going up everywhere as central banks seek to clamp down on rising inflation .

And in most areas, including the UK and US, they were expected to rise even further in the coming months.

Just as importantly, central banks are also reversing the quantitative easing (money-printing) schemes they introduced during the financial crisis. In practice that means selling large quantities of government bonds to investors, which invariably include big financial institutions.

This has already caused some problems.

When Liz Truss and Kwasi Kwarteng tabled their mini-budget last September, part of the reason it caused such chaos in financial markets was that they were concurrently trying to deal with an enormous influx of government bonds.

When interest rate expectations spiralled, causing a crisis in certain funds underlying the pensions market, it was seen by some as the canary in the economic coal mine – a sign of what can go wrong when interest rates lurch much higher.

In other words, everyone has suspected there may be unexploded bombs ahead, and since higher interest rates tend to trigger financial bombs (remember, nearly every financial instrument has an interest rate tucked somewhere beneath it), there was always a chance of further explosions as rates increased.

SVB

2. Silicon Valley Bank was a slightly unusual American bank whose demise can at least partly be traced back to those higher interest rates.

As the name suggests, it catered mostly to tech start-ups, which meant it had an unusual surfeit of deposits.

Founders would get big infusions of cash and plonk it straight into their accounts, and since they rarely took out loans (the usual business model of a bank is to take deposits and lend to customers), SVB had to put that money somewhere.

Fatefully, they put a lot of it into illiquid bonds which lost a lot of their value when interest rates rose.

But that wasn’t the only problem facing SVB.

The vast, vast majority of their deposits were big, very big. And under US regulations, only the first $250,000 of a customer’s deposits is protected by a system of deposit insurance.

Anything above that could be lost in the event of a bank’s insolvency. And since many of SVB’s deposit accounts contained many millions of dollars that meant many of these tech founders realised they could lose money if the bank collapsed. So they pulled their money out. A run began.

Interest rates were a part of the story, but so too were those rules on deposit insurance.

That this all happened under the noses of federal regulators comes back to another strand of the story: the tough post-financial crisis Dodd-Frank regulations had been watered down somewhat under Donald Trump.

That had a particular bearing on smallish banks like SVB which were deemed less worthy of scrutiny since they were seemingly less “systemically important”.

Silicon Valley Bank wasn’t the only American bank to face problems, by the way. So too was Signature Bank, a far older and somewhat more traditional New York bank, which had lurched headlong into the cryptocurrency sector.

And SVB also had a UK arm whose depositors saw what was happening in the US and likewise began to pull their money out.

SVBUK was bought in an emergency purchase by HSBC a week ago for the princely sum of one pound.

Not a traditional bailout of SVB

3. Silicon Valley Bank and Signature were “sort of” bailed out by the US authorities.

The “sort of” matters here because while this looked and walked like a bailout it wasn’t exactly what you’d call a traditional bailout.

The government didn’t nationalise the banks. But they did do something unusual: they said ALL depositors, not just those with savings less than $250,000, would have all their money insured.

They wouldn’t lose a penny. The US Treasury explained that this extraordinary action was being taken because their collapse would trigger “systemic” problems in banking.

This was, on the face of it, a little strange.

Since these banks were, from the perspective of regulation, “non-systemic”, then why were they suddenly “systemic” upon collapse?

That raised other questions: if SVB was systemic then what about the hundreds of other smallish banks dotted around America?

If they suffered a bank run then would their customers lose their uninsured deposits? Would the authorities guarantee all of their deposits?

These questions are concatenating around American communities and as a result people are pulling lots of money out of regional American banks and putting it into bigger banks instead.

It’s a serious confidence issue which is at least in part due to the slightly peculiar way in which the regulators intervened.

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All eyes on Credit Suisse

4. At this stage you’re probably wondering: what on earth has any of this got to do with Credit Suisse?

And actually the answer isn’t altogether straightforward.

This enormous and venerable Swiss bank didn’t have a business model that was anything like SVB’s.

It did have plenty of problems: a history of poor management going back many years.

It has long been considered vulnerable in the event of a crisis .

So the simplest explanation for what happened in the past week or so was that as fears rose about the state of the banking system, all eyes turned to Credit Suisse.

The slightly longer explanation is that the bank had also faced a series of unfortunate events: it had had to restate some of its accounts and then one of its leading investors, the Saudi National Bank, said it wouldn’t put any more money in.

Either way, in the days after SVB’s collapse, Credit Suisse’s share price cratered and its position looked increasingly precarious, culminating in its takeover (at the barrel of a gun) by the other big Swiss bank, UBS, over the weekend.

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The nature of this emergency takeover (another bailout in all but name, since the Swiss authorities have provided certain guarantees to UBS, backed by the Swiss taxpayer) is also worth scrutinising because much as with the American rescue, there may be some unpleasant unintended consequences.

Among the many things that happened during the takeover, a special class of bonds – AT1s – were made valueless.

These odd instruments – contingent convertible bonds as they’re sometimes called – are designed to lose some of their status in the event of a bank collapse, so on the face of it there’s nothing odd here.

However, in this case while all those holding onto the AT1s lost their money, those who owned common shares in Credit Suisse got some of their money back.

This might all sound a little esoteric – and it is.

But it’s of great consequence because it turns out there are rather a lot of people who own AT1s in various banks around the world who are all suddenly asking: hang on, are my bonds also likely to be less valuable than common equity in the event of a bank collapse?

In which case, why am I bothering paying for them.

In the early hours of the morning, the prices of these AT1s fell across the European banking world.

Echoes of 2008 and a potential credit crunch

5. Following all this chaos, leading central banks announced that they would activate regular “swap lines” – providing an easy way for big banks to get hold of dollars if they need them.

This is a standard part of the financial crisis playbook – and another reminder of how heightened nerves are.

It doesn’t necessarily mean we’re facing another financial crisis, as we did in 2008, but, well, the move has many not very enjoyable echoes to it.

And it’s highly likely that even if the current problems don’t trigger more bank failures or near failures, it will lead to economic consequences.

Typically in the face of these moments, banks tend to reduce their lending.

They rebuild their balance sheets and try to increase their levels of deposits, and the quid pro quo of that is to reduce the amount of credit they’re extending to businesses and households.

In other words, we may be facing a potential credit crunch (or a credit squeeze) in the coming months. That’s not pleasant.

And the drama might also have a bearing on the actions of central banks.

They were, as we covered, poised to raise interest rates again a number of times.

Now there are question marks over how far they’ll go. All of a sudden it’s a toss-up whether the Bank of England raises interest rates by another quarter point this week. So the travails of these obscure banks matter for all of us.

It is inherently impossible to know where this will head next.

Will there be further bank collapses? Certainly in the US many regional banks are seeing rapid outflows of deposits, raising the question of whether the Fed will step in to save them.

In the eurozone there are a fair few banks – including BNP Paribas and Deutsche Bank – which have quite a lot of debt to issue in the coming months.

But that being said, the financial system as a whole is in a better position than it was in 2008.

The big banks are well capitalised and their balance sheets look less toxic than they did back then (even though higher interest rates make some of their assets look a little more risky).

However, Credit Suisse was hardly undercapitalised. The episodes of the past weeks underline that if enough people are worried enough and pull out enough money, no bank is safe.

Confidence is key.