Like Schrödinger’s cat, is this bank dead or alive?

After a tumultuous week and weekend, everyone seems to be asking: is this another global financial meltdown?

• Bank runs, bailouts, rescues: are the ghosts of 2008 rising again? The Guardian
• Global banking is now inside Schrödinger’s box, The Financial Times
• What’s wrong with the banks, The Economist

Megan Greene discusses the idea, in The Financial Times, that the situation we are in with banks is like Schrödinger's Cat. The theory Schrödinger posited is this:

A cat, a flask of poison, and a radioactive source are placed in a sealed box. If an internal monitor (e.g. a Geiger counter) detects radioactivity (i.e. a single atom decaying), the flask is shattered, releasing the poison, which kills the cat. Is the cat dead or alive?

It is the core of quantum computing discussions, as this idea has created a new way of thinking about bits and bytes. Here's Megan's opening:

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.

Personally, I agree with Megan's view, but this means we are not in a contagion or a Global Financial Crisis, Part Two. I don’t see it. I see several banks with different issues, much of it created by a rising interest rate in the world's markets. Since 2008 and before, we have lived in a low interest environment. Banks, financial markets, governments and corporates are just not used to the fact that interest rates are rising. That’s what killed Silicon Valley Bank and, because SVB is the go-to West Coast American bank, their main competitor – First Trust Republic Bank – got taken down with them. But, if you look at the stats, they are similar but very different banks.

Source: Daily Mail

The main difference is that SVB were funding start-up ventures and supporting tech start-ups, whilst First Republic Bank were taking deposits of high net worth wealthy clients. Either way, both got caught up in the maelstrom.

Then you have Signature Bank. Signature Bank switched to a cryptocurrency strategy four years ago and, because of the crypto winter caused by FTX and other incidents, found itself in a different maelstrom and went down. Notably, they have been brought back to life by the New York Community Bank, and the only relationship with SVB is the nervousness of investors in their exposure to uninsured deposits.

To be clear, what this means, and it is common to all three failed banks, is that SVB, First Republic Bank and Signature Bank all had a high number of clients deposits not covered by the Federal Deposit Insurance Compensation (FDIC) scheme. This is where the panic rose, and hopefully after dealing with those issues, the meltdown is over.

On my own reflection, the real issues are related to the collapse of cryptocurrency valuations bringing down Signature Bank, whilst the rising interest rate environment brought down SVB, who for some mad reason had secured all their funds in HTM (Hold to Maturity) assets and, by association, First Republic Bank. This is not contagion or a global meltdown. It’s an issue of bad investments and bad management in a small number of US banks.

Completely separately, Credit Suisse got into crisis after a history of mistakes and mismanagement.

The question with Credit Suisse is how a bank that has been around for 170 years, allowed a culture of risk to arise that led demise. The main issues appear to be a loss of understanding of fractional reserve banking but, more importantly, a loss of understanding of risk management. It is a different issue.

What is fractional reserve banking?

Fractional reserve banking is a system in which only a fraction of bank deposits are required to be available for withdrawal. Banks only need to keep a specific amount of cash on hand and can create loans from the money you deposit.

Source: Investopedia*

This means that banks must have enough in reserves to cover the likelihood of depositors asking to withdraw cash. It’s the old thing around borrow short and lend long. To put that statement in context banks are borrowing your money, your deposits, to lend. They make profit by lending more at higher interest rates than the amount they pay you for holding your money. It’s a simple construct, but hard in practice as the question for a bank is: how much do I need to keep in cash (liquidity) to pay depositors if they want their money back?

Under regulatory rules, various figures apply in various jurisdictions, but the core is: what is the risk? What is the risk that our depositors will ask for their money back? Critically, how many depositors and when?

I liken it to building a church for Easter Sunday. Do we always keep enough for that day of the year when everyone turns up or do we take the risk of believing that people don’t turn up most of the time, and just keep enough for everyday? The problem with the latter is: what happens if they do all turn up on that day? That’s the dilemma of fractional reserve banking.

This is a core issue in all markets. For example:

But the more important question for Credit Suisse, as highlighted in my blog post last week, is how did they allow years of misreporting their accounts and allowing their risk controls to go wild?

In their latest annual report, which triggered the bank run, they  admitted “material weaknesses” in its internal controls over financial reporting and risk assessments in 2022 and 2021. The report stated that “material weakness could result in misstatements of account balances or disclosures that would result in a material misstatement to the annual financial statements of Credit Suisse”.

WTF?

Surely a bank of this repute would understand its risk exposures? Apparently not. That’s why the bank tripped over and, in a time of nervousness after the fall of the American banks, the timing was awful.

If it had been another time, another place …

Meantime, although the loss of four banks in just over a week may lead to a House of Cards or, as I prefer to call it, the Stairs of Death …

... I don’t see this as a financial contagion. I just see it as a group of banks who got into trouble over uninsured deposits, investments in securities that were illiquid and a bank that lost the plot. The problem is that it could lead to financial contagion because of four banks failing in a week. UBS shares have slumped since the takeover of Credit Suisse, and the whole banking sector is down. Let’s see what happens from here.

Useful links:

• Fractional Reserve Banking
• CoCo bonds
• The impact of CoCo bonds on the markets
• There Once Was a Bank Called Credit Suisse
• ECB tries to settle market after UBS deal wipes out $17bn of AT1 bonds
• Credit Suisse says $17 billion of its debt now worthless, angering bondholders
• UBS Slumps After Agreeing to Buy Credit Suisse in Historic Deal
• Bank shares slide after UBS agrees ‘emergency rescue’ of Credit Suisse
• FTSE drops heavily after Credit Suisse rescue deal fails to calm markets

 

 

* this definition is disputed