Banking problems are growth problems

20 March 2023

Just as the global economic outlook has started to look up, along comes trouble in the banking sector. In less than a fortnight three mid-sized US banks have failed and Credit Suisse has been fast tracked into a takeover by UBS.

The events of the last fortnight represent the most challenging moment for the banking system since the early days of the financial crisis in 2008. As has happened so often before, a combination of rising interest rates and slowing growth are testing the financial system.

The big lesson from 2008 is that the authorities need to move swiftly and in scale to counter a banking crisis. The response from the authorities in the US and Switzerland has been forceful, but so far it has not calmed markets.

The demise of Silicon Valley Bank (SVB), America’s 16th largest bank, on 9 March was the biggest bank failure since the 2008 financial crisis. The tech companies who were its main customers, facing a more difficult climate, had sought to draw down on their facilities. To meet demand for cash SVB was forced to liquidate holdings of US mortgage-backed securities at a loss, raising the possibility that the bank would be unable to fulfil its commitments. Investors took fright and rushed to withdraw their funds, forcing the regulator to take control. SVB’s failure came the day after Silvergate Capital announced the liquidation of its bank and two days before Signature Bank was taken over by regulators. In the age of digital bank accounts, where rumours spread like wildfire across the internet, bank runs can happen very quickly.

All three of these banks were thought by regulators to be too small and specialised to be important to the wider functioning of the banking system. Indeed, in 2018 the regulations required under the Dodd-Frank Act of 2010 were eased for regional and midsized banks, including SVB. Yet faced with a crisis, and the risk that other regional banks could come under pressure, the US authorities reacted forcefully.

To reassure markets and limit contagion policymakers introduced two measures. First, to reduce the risk of further bank runs the US Treasury lifted the $250,000 bank deposit guarantee for SVB and Signature Bank, ensuring all deposits at these institutions will be covered in full. Second, the Federal Reserve has boosted the value and the liquidity of bank assets by undertaking to provide one-year loans to banks against the par value of holdings of US Treasuries and certain other related assets such as mortgage debt.

The par or face value is above the current market value of these assets and US banks have rushed to avail themselves of the offer, taking over £300bn of loans from the Fed in the last week. After almost a year of quantitative tightening, in which the Fed shrunk its balance sheet by selling bonds it has bought since 2008, the Fed’s balance sheet is expanding again.

The major banks have also stepped in. In a show of confidence a group of major US banks last Thursday deposited $30bn with First Republic Bank. It had suffered a flight of deposits and a precipitous decline in its share price following the failure of SVB.

In terms of financial stability, the response of the Treasury and the Fed, and the support offered by the big banks, is shock and awe stuff. But it hasn’t, so far, turned the tide. Shares in First Republic dropped 35% on Friday and are down by over 80% this month. Other mid-tier regional banks also saw further decline in their share price. Depositors have carried on shifting funds out of smaller US banks into larger ones.

Zurich-based Credit Suisse is a global bank with a strong capital position, utterly different in scale and business model from SVB in California. But profitability has been poor and Credit Suisse’s standing has been tarnished, including through involvement with the collapsed financial services firm Greensill and the hedge fund Archegos. Even before this latest crisis, in late February, Credit Suisse shares were trading at just 20% of their value two years earlier.

The emergence of weaknesses in the US regional banks in the last fortnight prompted investors to look elsewhere for frailties. The timing could hardly have been worse for Credit Suisse coinciding with an announcement from the bank that it had found ‘material weaknesses’ in its financial reporting. Then came the news that the bank’s biggest shareholder, Saudi National Bank, would not provide it with more capital.

Credit Suisse shares dropped by almost 30% last Wednesday, only to bounce back on Thursday following the announcement by the Swiss National Bank that it would provide over $50bn of liquidity. Renewed selling on Friday, with the share price closing 8% down, and the loss of further deposits, led to yesterday’s takeover of Credit Suisse by UBS.

So what happens next and what does this mean for the global economy?

First, the good news. The banking sector is more tightly regulated than it was 15 years ago. Banks are better capitalised, run higher levels of liquidity and have been subject to rigorous stress tests to gauge their ability to cope with shocks. Medium-sized European banks have not had the easier regulatory regime of their US counterparts. The authorities are on high alert and are determined to move quickly and decisively. This feels different from 2008.

Now for the bad news. The last fortnight shows that investor sentiment can turn quickly and that deposits are footloose. Problems can migrate quickly and unexpectedly from one part of the system to another. Even aggressive policy interventions, through the provision of liquidity and protecting deposits, don’t always turn the tide. Sometimes, as in the case with Credit Suisse, more radical change is needed.

Slowing growth spells stress for households and corporates and rising levels of loan losses for banks. The value of assets can fall rapidly when interest rates rise. SVB’s troubles were due to a failure to protect itself against the risk of higher interest rates hitting the value of its mortgage portfolio.

Material stress in the banking system tends to dampen business confidence and leads to a tightening of financial conditions. Banks pull back on lending and falling equity and bond prices translate into a higher cost of capital. Even before the current problems in the banking sector emerged credit conditions had tightened significantly. That process has further to run and it adds to the risks to growth.

Our own measure of financial stress for the UK, created by my colleague Edoardo, rose sharply following September’s mini-budget before falling back in February. Edoardo expects it to surge in March when all the data are available. For details see: https://blogs.deloitte.co.uk/mondaybriefing/2023/02/the-uk-financial-stress-index.html

We would also expect the damage to the real economy from financial stress, as measured by our Economic Stress Index, to keep trending higher as problems in the banking system and the effect of higher interest rates feed through. See: https://blogs.deloitte.co.uk/mondaybriefing/2023/02/measuring-economic-stress.html

Risk can radiate out from the banks to other parts of the financial system. Swings in the prices of government bonds driven by last week’s events hit market liquidity and raised concerns about the smooth operation of this crucial market. (On Sunday a group of the world’s leading central banks responded by announcing a set of measures to improve market liquidity.) Following the tightening of banking regulation after the financial crisis a good deal of risk-taking activity has migrated to the less regulated part of the system, the so-called shadow banking sector, including private equity, hedge funds and money market funds. Although thought not to be of systemic importance to the economy, the shadow banking sector accounts for a good deal of financial activity. It is not clear how it would cope if it faced losses and investor flight as have been seen in a handful of US banks in the last fortnight. The meltdown in liability-driven investment strategies in UK pension funds triggered by a fall in the value of UK gilts last September is a recent example of how financial structures can unravel when asset prices fall.

Financial markets have interpreted last week’s turmoil as a deflationary shock that will slow growth and reduce the need for central banks to raise interest rates. The standard response of central banks to financial shocks is to loosen, not tighten policy. This creates a dilemma for central banks. Inflation remains far too high and the Fed and the European Central Bank have spent the last month signalling that they plan to raise rates.

The ECB pressed ahead with a 50bp rate rise last Wednesday, raising rates to 3.0%, but suggested it would be cautious about making further increases. The Fed has a difficult call to make when it meets to set rates on Wednesday. If it raises US rates it risks overtightening financial conditions, hitting growth. If it leaves rates unchanged markets might think it has gone soft on inflation.

Until recently the economic news has generally been positive. Lower energy prices and the reopening of China’s economy have caused the IMF and the OECD to raise their forecasts for global. Last Wednesday the UK’s official forecaster, the Office for Budget Responsibility, reversed course and said the UK would avoid a recession this year. That now seems premature. Recent turmoil in the banking system raises the odds of a recession. By how much depends on what other problems emerge and on the skills of policymakers.

For the latest charts and data on health and economics, visit our Economics Monitor:
https://www2.deloitte.com/uk/en/pages/finance/articles/covid-19-economics-monitor.html

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 5.3% at 7,335. Global equities suffered from turbulence in banking stocks after the collapse of SVB in the US and growing concerns about the creditworthiness of Credit Suisse.

Banking

UBS agreed to take over Credit Suisse for $3.25bn after a $54bn credit line provided by the Swiss National Bank (SNB) during the week failed to restore market confidence in Credit Suisse
The SNB will provide a substantial credit line to UBS and the government will protect against up to $10bn of losses as part of the deal
The FT reports that the Biden administration is coming under pressure to increase the bank deposit guarantee for all US banks from $250,000 following the removal of the limit for SVB and Signature Bank
The US Department of Justice announced a probe into SVB’s collapse, including an investigation of stock sales made by SVB staff prior to the default
HSBC reached a deal to buy SVB’s UK business with HSBC’s chief executive Noel Quinn stating the acquisition “makes excellent strategic sense”
Private investment firms show interest in SVB’s $74bn loan book after the bank was shut down by regulators
Six largest Wall Street banks lost 13% of in market capitalisation last week, following the largest bank failure since 2008
The US banking sector’s outlook has been downgraded by the credit agency Moody’s as SVB’s collapse lead to “rapid deterioration in the operating environment”
European banks lost over 10% in value last week as jitters in the US banking sector spread to the continent
Credit rating agencies Fitch and S&P cut First Republic Bank’s rating despite large US banks depositing $30bn
Lloyds Banking Group chief executive Charlie Nunn said UK banks have not seen a “flight to quality” among deposits following the SVB collapse

UK Spring Budget 2023

The UK chancellor Jeremy Hunt announced an easing of fiscal policy following better than expected growth and borrowing forecasts by the OBR
The UK is not to enter a technical recession in 2023, according to the OBR, as it upgraded its growth forecasts for the year from -1.4% to -0.2%
The OBR revised its inflation forecast down to 2.9% by the end of 2023
Living standards are still expected to fall by a record 5.7% over this year and the next, the sharpest fall since the 1950s, according to the OBR
The chancellor used the additional fiscal headroom to announce tax breaks for business investment, the extension of the energy price cap until June, the scrapping of the lifetime pension allowance and the extension of free childcare to one and two-year-olds in England
Jeremy Hunt pledged to establish 12 investment zones in the UK that would benefit from tax incentives and additional funding
The chancellor also promised to increase defence spending by £11bn over the next five years
Fuel duty has been frozen and the 5p VAT cut on fuel was confirmed in the budget
The OBR projects that the tax burden in the UK is to hit a record high as the chancellor froze income tax thresholds adding almost £30bn to revenues every year
The OBR estimated the UK’s debt-to-GDP ratio to hit 94.6% in 2028, three percentage points lower than forecast back in November

Economics

Corporate insolvencies rose by 17% in England and Wales in the year to February
UK wage growth slowed to 5.7% in the three months to January as the labour market cools, especially as employers scale back hiring activities
Business confidence in the UK rose to the highest level in 12 months, according to S&P Global
The UK government has agreed to a new pay deal with NHS unions which may end the industrial dispute
The ECB increased interest rates by 0.5 percentage points to 3% despite turbulence in the banking sector
The Fed announced an emergency lending facility for US banks and also assured that all SVB’s deposits would be made whole
US inflation fell to 6% in February, less than hoped by the Fed and maintaining the pressure on for further interest rate hikes
US retail sales dropped more than expected in February, falling by 0.4% in a sign of a cooling in consumer demand
The price of Brent crude oil fell last week to a low of $72 a barrel
The banking turmoil led to a rally in US treasuries last week with yields falling at the fastest pace since the 1980s as investors sought refuge
China’s economy began its recovery in 2023 after positive readings from retail sales and industrial output
Russia announced it will impose a 5% windfall tax on large businesses excluding oil, gas and coal firms and which will be backdated to 2021

Business

Foxconn, supplier of Apple products, reports it expects consumer electronic demand to fall this year after posting a 10% fall in its Q4 2022 profits
BMW announced it would stop increasing the price of its cars this year as the global semiconductor crisis eases further
OpenAI released ChatGPT-4 as a subscription-based service. The company claims the new AI model exhibits “human-level performance” on several academic and professional benchmarks
Meta announced another round of job cuts as it will lay off 10,000 workers and close 5,000 open vacancies
UK department store John Lewis is considering ending its staff-only ownership model to raise new capital

Global and political developments

The International Criminal Court issued an arrest warrant for Russian president Vladimir Putin over the deportation of children from Ukraine
US defence secretary Lloyd Austin met with Russian counterpart Sergei Shoigu to discuss the downing of a US surveillance drone over the Black Sea
The IMF finalised a four-year lending programme for Ukraine totalling $15.6bn to help the country devasted by the Russian invasion
French president Emmanuel Macron resorted to a presidential decree to pass his pension reform that would increase the retirement age to 64
President Andrzej Duda confirmed that Poland is set to send four fighter jets to Ukraine in the coming days
Poland detained nine people suspected of spying on behalf of Russia
The UK and Australian governments have banned the use of the social media app TikTok on government devices

And finally… a former McDonald’s employee discovered that the fast-food restaurant’s mayonnaise-style sauce is a potent cleaner and polisher of silver and copper – McPolish

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