The writer is an FT contributing editor
The famous quantum mechanics thought experiment posits that if a cat is sealed in a box with a deadly substance, you can’t know whether it is still alive until you open said box. In the meantime, it is simultaneously alive and dead. And so it is with banking today: we can’t know if the past week was a series of idiosyncratic, containable issues or the start of a 2008-style banking crisis. At the moment it is both.
Investors and depositors must not only believe that banks have good capital ratios, ample access to liquidity and behave responsibly, but also that the supervisory and regulatory architecture put in place after 2008 to save the system works. In the short term, there can be gradations of confidence in all of this. But when we finally look in the box, investors must either trust all of these things or none. It is a binary outcome: the cat can’t be a little bit dead.
Reason points to the recent banking instability being a series of containable issues, mostly based on supervisory and management issues. Silicon Valley Bank, Silvergate Bank and Signature Bank were unusually exposed to interest rate risk through both their clientele (itself a phenomenon of a low-rate environment) and their assets (long-term bonds that had to be sold at a huge loss to redeem deposits). First Republic, with a wealthy depositor base that might largely be uninsured, has also been caught up in concerns about liquidity. Credit Suisse, in trouble many times before for a litany of reasons, is now dealing with both confidence and liquidity concerns.
The good news is a lot has changed since 2008. Banks are far better capitalised and regulated than before the global financial crisis. And as awful as that period was, we learnt many lessons from it, among them the importance of swift, decisive action to stem contagion.
Central banks immediately dusted off the playbook for addressing a liquidity crisis and stepped in as lenders of last resort. The US Federal Reserve, Treasury and FDIC guaranteed all deposits for SVB and Signature Bank, and the Fed created a new lending programme, the Bank Term Funding Program, for banks with underwater securities on the books to access at par. The Swiss National Bank extended a credit line of up to SFr50bn ($54bn) to Credit Suisse.
The bad news is that so far trust in the banking sector has not been restored. A week after the US programmes were announced, First Republic remains under pressure — even after receiving $30bn in deposits from larger banks. Its shares fell 33 per cent on Friday. All of the banks in the KRE banking ETF were down; the index closed off by 6 per cent. Fed data showed it loaned $11.9bn through its new facility in the week up until last Thursday and a record high of $152.9bn through its usually stigmatised discount window. Clearly, liquidity is a concern across the US system. And despite the new credit line, Credit Suisse and its rival UBS AG have spent the weekend negotiating an acquisition.
Central banks and regulators must do more to restore confidence. Fundamental trust in the banking system is wobbling. And I worry more toxic things might still be added to Schrödinger’s box. Commercial real estate loans account for about 28 per cent of small banks’ loans in the US (relative to 8 per cent for the largest banks). Some of these are underwater given high interest rates and the pandemic shift to working from home. If even a few small banks have to write down assets, solvency questions will become contagious.
Another risk lies in private markets. They do not have to mark to market, and have booked much smaller paper losses than public markets over the past year. They may delay crystallising losses in the hopes that asset values reflate in the meantime. If assets continue to fall, however, the losses could be staggering. Private markets could undermine financial stability.
We shouldn’t assume the cat is dead and a banking crisis is upon us, but we will keep hitting pockets of market dislocation as central banks continue to withdraw liquidity by raising rates and shrinking balance sheets. This is the third time in two decades we’ve had banking issues, after the financial crisis and eurozone crisis. More needs to be done to rebuild and maintain confidence in the system. Even if the cat is alive this time, we can’t assume it has nine lives.