Is the banking crisis over?

In past financial crises, this column has been highly critical of the regulatory reaction functions, and the real-time assessments of decision-makers, which have typically been glacial and prone to error. And while there is no doubt the Swiss government shot itself (and Credit Suisse) in the foot with its ham-fisted management of what was an orchestrated speculative attack on a business that could have continued operating, the global regulatory response has been generally impressive.

Reserve Bank of Australia’s governor Phil Lowe recently provided an excellent summary of the situation, which echoed our own thoughts. A key lesson has been that internet-enabled banking means governments, regulators and banks have to revisit assumptions regarding the stickiness of deposits, which supply 60-80 per cent of all bank funding.

In the case of Silicon Valley Bank, depositors tried to withdraw $US42 billion in a single day, which killed that institution. While US bank deposits already attracted a guarantee of up to $US250,000, this had to be extended by the authorities to an unconditional guarantee of all deposits, irrespective of size.

If the US government had made this unequivocal guarantee clear one week earlier, Silicon Valley would never have faced deposit flight given this money would have been risk-free. The same observation is true of the Credit Suisse assault, which was characterised by a digital deposit run triggered by hedge funds, which engineered hyperbolic media coverage while shorting illiquid Credit Suisse securities to purvey the impression that there was something fundamentally wrong with the bank when it was actually okay.

Had the Swiss authorities made it clear that all Credit Suisse deposits were government-guaranteed, there would never have been a deposit run. The Swiss would not have needed to give UBS and Credit Suisse 150 billion Swiss francs of cheap loans nor furnish UBS with an indemnity for at least 9 billion Swiss francs of potential future losses. Credit Suisse shareholders would not have lost 90 per cent of their money, and the Swiss would not have had to forever tarnish their regulatory reputation by zeroing hybrid holders ahead of equity. (Credit Suisse’s depositors and senior and Tier 2 bondholders did not suffer losses.)

Consider the counter-factual, which was Deutsche Bank. We had told our investors that Credit Suisse would be targeted after Silicon Valley and asserted that hedge funds would then turn their crosshairs to Deutsche Bank. And this is what happened. The difference with Deutsche Bank was that after its equity started to get hammered, the German chancellor came out and signalled that Germany would protect its national champion. Concurrently, European regulators announced they would be investigating questionable price action in Credit Suisse and Deutsche Bank securities for market manipulation.

Short sellers knew that Europe had already banned naked shorts on their government bonds. They could easily do exactly the same thing on bank securities, as they did during the 2008 crisis. So the hedgies ran for the hills; Deustche’s stock soared; sensationalist media were scorned; and the notion that speculators could precipitate high-velocity deposit runs was buried by explicit government guarantees.

Problems with guarantees

There are two issues with guarantees. The first is they should be priced. In many countries, banks pay a premium for public deposit insurance. In Australia, we have the so-called big bank tax, which is an 0.06 per cent annual levy larger banks pay the Commonwealth for the implicit guarantee of their bonds and wholesale deposits (above the capped $250,000 guarantee). This column has always argued that banks should pay for the explicit deposit guarantee and that logic remains robust (the implicit guarantee is already priced).

A second concern is moral hazard. Yet the practical reality is that bank executives are so aggressively regulated nowadays, it is all but impossible for them to behave in a systematically reckless fashion.

Lowe touched on many of these points, including the importance of ensuring that shareholders wear losses before creditors situated higher up the capital stack. And he noted that Australia was recognised as a global leader in terms of the unquestionably strong capital banks are forced to hold, the exceptional liquidity they need to maintain as a buffer against deposit runs, and the way they are required to actively hedge-out interest rate risks.

For a decade we claimed – in the face of much opposition – that the big banks should be forced to massively de-lever their balance sheets. The 2014 financial system inquiry agreed, and the major banks were compelled to raise $150 billion of fresh equity capital. For years we asserted that banks should only hold government bonds as a regulatory liquidity buffer, calling for the closure of the Committed Liquidity Facility (CLF), which was full of riskier and less liquid assets that overseas banks are still allowed to hold.

The Australian Prudential Regulation Authority finally wound the CLF down in 2022 in the face of resistance from bankers hoping to pick up more yield in illiquid assets issued by them and their peers, such as internal loans, senior-ranking bank bonds, and residential-mortgage-backed securities (RMBS).

In 2021 and 2022, ANZ, CBA and UBS analysts argued that Aussie banks should be permitted to run lower liquidity coverage ratios of 120 or 125 per cent as a result of the CLF being closed and the fact our banks were above the 100 per cent regulatory minimum. We brought this to APRA’s attention and countered that it would be irresponsible to allow local banks to drop their LCRs to levels that would have been below European standards. To its immense credit, ARPA hammered this same point home, reminding banks that investors expected them to report LCRs over 130 per cent.

More recently, banks have lobbied APRA to allow them to include relatively illiquid covered bank bonds and RMBS as a liquidity buffer instead of holding government bonds. Last year we engaged with APRA to explain why this was a terrible idea, and the regulator has since made it clear it concurred.

Finally, in 2017 we warned APRA that it should not allow banks or insurers to issue hybrids that are written off in a crisis ahead of equity, given that this inverts the capital structure hierarchy and provides controlling shareholders with a conflicted incentive to manipulate this outcome to protect themselves, which is exactly what happened with Credit Suisse.

Almost all Aussie bank hybrids automatically convert into equity in these scenarios, and cannot, therefore, suffer the fate of Credit Suisse’s securities. But APRA did approve one bond from Genworth and a hybrid issued by ME Bank that could have been automatically written off ahead of equity simply because shareholders in these businesses wanted to design these securities to minimise their own losses. The Swiss debacle has demonstrated just how dangerous this can be.

Shadow regulation

The bottom line is that “market discipline” via activist creditors is an important form of shadow regulation that can support government agencies. It is, of course, much easier to blindly reach for risk in the search for yield.

Some Aussie investors have been badly burned by buying Credit Suisse hybrids in the name of capturing higher illiquidity premiums. We saw a similar theme play out during the pandemic with Virgin’s popular senior bonds, which were wiped out when Virgin went under. History has a habit of rhyming if you do not study it.

Many assumed the search for yield came with no risk in a low-rate world. But we are watching the downside materialise. Global corporate defaults are running at their highest level since 2009. US corporate insolvencies are the loftiest since 2010. In Australia, the RBA reports that 15 per cent of all borrowers could have negative cash flows while 16 per cent may not be able to refinance existing loans.

While the arrears reported by banks remain historically very low, and have yet to materially tick up, non-bank arrears rates are starting to soar. This is borne out in the arrears statistics reported on RMBS deals, which for the sub-prime (or non-conforming) lenders have begun to spike.

Since 2008 regulators have prevented banks from lending to higher-risk borrowers, who have been forced to seek liquidity from unregulated non-bank lenders. The worry is that none of these non-banks existed the last time Australia had a real default cycle, which was during the 1991 recession.

First published in the AFR.