The US banking contagion has been contained but we’re not yet out of the woods

By Carlton Joseph

Carlton Joseph

The month of March witnessed the failure of California-based Silicon Valley Bank (SVB), a major lender to the tech industry. The collapse panicked markets, inflicting pain on weaker financial institutions who were also struggling with soaring interest rate problems.  The result, a week later another regional bank, Signature Bank closed, and a week later, First Republic Bank had to be propped up.  Most significant, Credit Suisse, a big global lender collapsed and was acquired by UBS, a global firm providing financial services in over 50 countries, for $3.2 billion.  Immediately, six large central banks: The Federal Reserve (Fed), the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Canada and the Bank of Japan decided to jointly reassure global financial markets that there was enough funding for global institutions amid the current stressed market conditions.

While the central banks, the regulators and governments have stepped in to contain contagion, there is still a lot of uncertainty.  As part of the rescue deal, the Swiss regulators required that $17 billion of Credit Suisse’s Additional Tier 1 (AT1) debt be written down to zero, AT1 bonds is a type of debt issued by banks that are designed in a way so that investors claims disappear at times of distress. This requirement transferred more of the risk of a systemic bank failure away from depositors and on to bondholders, and is a method of strengthening bank balance sheets and avoiding contagion between banks, or the need for taxpayer-funded bailouts. 

This decision has significantly impacted the multi-billion AT1 market, and created a controversy because bond holders, were penalized more than shareholders.  The Financial Times reported that shareholders were not wiped out as part of the Credit Suisse sale to UBS, but that some investors believe there is an, “obvious breach of the hierarchy of claims,” and a widespread sense that AT1 would be in the line of fire after equity.

Fortunately, the U.S. banking contagion is unlikely to spill over to Canadian banks, because the six big banks in Canada have avoided failures that have plagued banks in the US and Europe.  They emerged stronger from the 2008 global financial crisis due to prudent regulations, and has since built a reputation for financial stability.  They accomplished this by focusing on domestic lending, and the majority of their earnings come from serving local clients.  In Canada, the financial regulator took permanent control of the assets of Silicon Valley Bank’s Canadian branch, and Canada’s Finance Minister, Chrystia Freeland, promptly defended the country’s financial institutions, saying they have capital to withstand “periods of turbulence” and prudent risk management.  

In fact, with billions of dollars of excess capital and share prices close to record highs, Canadian banks are seeking to expand in the United States, whose more fragmented market offers more opportunity to grow, since they already own approximately 80% of their domestic market.  Recently, Royal bank, TD Bank, BOM and CIBC have expanded into the US, by buying regional lenders, to benefit from strong growth in second-tier U.S. cities, and in January, the Fed approved Bank of Montreal (BOM) request to acquire San Francisco based Bank of the West for $16.3 billion.  The deal gives BMO, a large-scale presence in California, enables it to add 1.8 million customers, and give BMO the ability to deploy almost all of its excess capital. 

Meanwhile in the US, Trump, Republicans, and a few Democrat lawmakers were removing regulations that were implemented to stop banks and the financial system from crumbling.  The 2010 Dodd-Frank law, that created stricter regulations for banks with at least $50 billion in assets to undergo annual stress tests, was dismantled and replaced with the 2018 banking deregulation law. This new law got rid of the $50 billion threshold, only banks with $250 billion plus assets would have to undergo annual stress tests.  Many mid-sized banks, including SVB, argued that Dodd-Frank regulations was needlessly encumbering them, because they did not represent systemic risks and it required the company to spend time and money complying with rules instead of providing loans to job-creators.  SVB president, Greg Becker wrote, having to deal with the Dodd-Frank regulations “would stifle our ability to provide credit to our clients without any meaningful corresponding reduction in risk.”

Silicon Valley Bank

Interestingly, the Fed, Congress, businesses and Americans acknowledge that something is wrong with the US financial sector, but there is no agreement on the source of the problem.  A recent Fed report criticized its own delay in recognizing and addressing problems at SVB, and changes in the supervision of banks resulting from the 2018 banking deregulation law. They are considering higher capital or liquidity requirements, in some cases, until there are better safeguards in place at a bank to protect against risk.  US Lawmakers are considering options for holding bank executives accountable for their mismanagement.  

Recent bank failures could result in tighter credit conditions for households and businesses, hiring, inflation and negatively impact economic activity.  Warren Buffett criticized how politicians, regulators and the press had handled the recent bank failures saying:  their “very poor” messaging has unnecessarily frightened depositors and that there must be punishment for people who do the wrong thing.  Congress and the Fed need to fix the problem immediately.

The fallout from the recent banking crisis is likely to push the US economy into a mild recession later this year, and the geopolitical landscape, especially decoupling from China, tension with Saudi Arabia, and the war in Ukraine, that is feeding inflation, is of serious concern.  Banks across the world are still adjusting to the steep surge in interest rates, and underdeveloped countries are experiencing lower income and compensation growth, higher poverty rates, and lower employment.  The bank failures have raised questions about the strength and durability of the US banking system, and KBW Regional Banking Index shares hit an annual low as investors moved out of regional banking stocks, especially mid-sized lenders, indicating that investor confidence is weak.

The speed at which clients withdrew their funds from SVB shows how quickly a bank run can occur in the digital age.  Central banks’ intervention is mandatory in order to make changes in the global financial architecture, with an increase role for regulators.  People with absolutely no banking, financial or business background, elected to Congress, because of popularity; or financed by monied puppet masters, must not be allowed to make decisions on important financial issues that affect the global population.

(Trinidad-born Carlton Joseph who lives in Washington D.C., is a close observer of political developments in the United States.)