So, farewell then to Credit Suisse, which has been sold at a cut price to UBS. Shareholders have lost almost all their money, while the owners of the bank’s riskiest bonds have lost the lot. This prompts three questions: what when wrong? what might happen next? and how should the authorities respond?
Investors have been increasingly nervous about the banking sector after the collapse of Silicon Valley Bank (SVB) in the US. In a nutshell, SVB took large deposits from cash-rich tech companies and parked them in long-term government bonds issued by the US Treasury. It was therefore operating more like a pooled investment vehicle than a normal bank.
These trades went sour when the US central bank raised interest rates aggressively last year, which simultaneously undermined confidence in the tech sector and caused large losses on SVB’s bond portfolio. This combination set off a death spiral of deposit outflows and the need to sell even more assets at ever lower prices.
To put it simply, Credit Suisse was also brought down by a good old-fashioned bank run. Personal and business customers withdrew their money and investors dumped their shares.
But why Credit Suisse? It was not an obvious outlier. Unlike SVB, it had a large and diversified balance sheet and client base, and decent capital and liquidity ratios. It was sufficiently big that it was unlikely to be allowed to fail completely. And its profitability was no worse than many other European banks.
However, doubts had been swirling around Credit Suisse for many years, thanks to poor management and even worse governance. Low points included the bank’s involvement in a series of financial scandals, notably the collapses of Greensill Capital and the hedge fund Archegos, and repeated concerns over lax internal controls.
The writing was already on the wall on March 9, when the bank had to delay the publication of its annual report after some last minute questions were raised by the US Securities and Exchange Commission (SEC). Not a great look.
The coup de grace was delivered on March 15 when Ammar Al Khudairy, the chairman of Credit Suisse’s largest investor Saudi National Bank (SNB), said it would not be adding to its shareholding.
It is tempting to think of this as ‘doing a Ratner’, after the UK businessman who trashed his own products in a light-hearted speech that spectacularly backfired. That would be harsh. SNB already owned close to the regulatory limit of 10% of Credit Suisse’s shares. Mr Al Khudairy also backed Credit Suisse’s long-term plans and said that he did not think the bank would need any more money. But the damage was done. If even the mega-rich Saudis were apparently unwilling to increase their exposure to Credit Suisse, why should smaller players take the risk?
So, what next? The rosy view is that SVB and Credit Suisse were exceptions. There is something in this. The circumstances that led to their collapse may not have been unique, but they were at least relatively unusual. To borrow from Gerard Ratner, they were ‘crap’ banks.
Small and mid-sized banks in the US are also not subject to the same liquidity rules and stress tests as bigger ones – or those in the UK. Indeed, the larger US banks have been flooded with new deposits as nervous customers have moved funds to what should be a safer home. The run on some banks has therefore actually benefited others.
But there is a less sanguine take. The fact that Credit Suisse’s healthy-looking balance sheet and financial ratios did not save it from a bank run shows how crises of confidence can gain a momentum of their own. History has taught us that banking failures are like London buses – you wait ages for one, and then three come along at once. Others may still follow.
What’s more, it is important not to lose sight of the bigger picture. The long era of cheap money is now over and this will expose many more problems.
Even before the failures of SVB and Credit Suisse, the sharp rise in market interest rates had already blown up the ‘liability-driven investment’ strategies which had been adopted by many UK pensions funds. Indeed, ‘LDI’ has now been added to the long list of toxic three-letter acronyms.
In the real economy, higher borrowing costs and increased uncertainty have already slammed activity in the housing market, both across Europe and in the US. It is impossible to say exactly which ticking timebomb will go off next, but there will surely be more.
Given all these problems, what should the authorities do? This is a difficult balancing act. Many others have already commented on the classic problem of ‘moral hazard’, where bailing out failing institutions may simply encourage more risky behaviour in future. The US authorities have arguably gone too far already.
On top of this, it is simply unrealistic to expect any regulatory system to prevent any bank from failing, ever. Banks may be special in some respects. They are more vulnerable to contagious losses of confidence, and are systemically important to the wider economy in ways that other sectors are not. But they are still private businesses and need to be subject to the discipline of the market.
Finally, a more immediate question is what this means for interest rates. The European Central Bank raised its key rates by another half point last Thursday, despite the turmoil, but hinted that it might move less aggressively in future. The US Fed and the Bank of England are widely expected to err on the side of caution at their rate-setting meetings this week.
If the question is ‘should the Bank of England pause on rates simply because of the banking crisis?’, my answer would be ‘no’. The Monetary Policy Committee’s (MPC’s) remit is monetary stability and interest rates should be set with sights on the inflation target.
Admittedly, more turmoil in the banks could drag the whole economy down and therefore mean that inflation falls too far. But we are not at that stage yet, and the Bank has other tools that it can use to protect financial stability, such as temporary liquidity support, without pivoting on interest rates.
Nonetheless, there were already some compelling reasons for the MPC to pause, including signs that pipeline cost pressures are easing and that wage inflation has peaked. The problems in the banking sector and housing market also illustrate the point that the full effects of the previous rate increases have yet to come through. So even if Credit Suisse had survived the weekend, I would be voting for ‘no change’ in UK rates this week. At most, I would expect one final quarter point hike.
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