No repeat of the 2008 global financial crisis but other dangers lurk

In the US, large banks remain safe but there is little political appetite to throw fiscal support at the smaller, failing banks
In Europe, the shock that Credit Suisse’s AT1 bondholders were made to absorb losses first, continues to reverberate

Chris Iggo

Published: 3:45pm, 5 Apr 2023

Why you can trust SCMP

This is not 2008. But market confidence in banks has been rocked and investors have had to digest significant losses in both the equity and credit markets. There may be more problems ahead as investors withdraw from certain bank-related assets and concerns remain about deposits.

There is also the risk of credit impairments, losses in other sectors such as real estate, and a wave of banks reporting provisions for loan losses. The interest rate market seems to know how this story will end – with rate cuts. If they materialise, fixed income returns will outrun those on cash.

Banks fail when they do not hold enough capital to absorb losses, when they are not able to meet deposit outflows, or when they face a general lack of customers, and investor and counterparty confidence prevents them continuing with business as usual. Valuing a bank from an equity or creditworthiness point of view relies on having transparency on all these things.

But, as events have highlighted, things move quickly. In a world of digital banking, deposit flight can be rapid – and this speed can outpace a bank’s ability to liquidate its assets to meet the outflows. The question for investors now is whether a systemic interest rate shock becomes a credit shock?

If this happens, then valuations of banks must consider potential additional realised or marked-to-market (accounting) losses on their credit and securities portfolios, the increased costs of funding to try and retain deposits, and the provisioning against loan losses as the economy deteriorates with tighter credit conditions. The further underperformance of bank equity and credit assets could be the result.

Policy plays a role in facing a banking crisis. Regulators and governments can provide insurance against deposit losses and/or a backstop to the valuation of assets and facilities which allow banks to use collateral to meet their liquidity needs.

The problem is that insuring all deposits in a system would require more than the funded insurance facilities that exist today. Providing a backstop to asset valuations is also problematic when credit assets become impaired – which was the case in 2008.

A branch of Northern Rock bank in London on February 18, 2008. Britain nationalised the bank in the global financial crisis after exposure to the credit crunch forced the bank to seek emergency help from the Bank of England, sparking the first run on a British bank in recent history. Photo: AFP

If the bank assets are US Treasuries or similar high-quality securities with a redeemable face value, then central banks can provide facilities to swap them for liquidity either on a temporary or permanent basis, i.e. take the assets onto their balance sheet. But if there are system-wide credit impairments that threaten solvency, this tends to become a fiscal issue.

This is not a 2008 situation. But no crisis is ever the same. Large US banks have been highly regulated since the global financial crisis and have doubled their core equity capital since. They are subject to annual stress tests that assess bank capital requirements against adverse economic scenarios like a recession, rising unemployment and a decline in residential property prices.

The issue now is that smaller banks are not subject to the same tests nor scenarios of rising interest rates.

Interestingly, the last Federal Deposit Insurance Corporation (FDIC) Quarterly Banking Review did identify the problem of unrealised losses in both available-for-sale and held-to-maturity portfolios (US$620 billion in the final quarter of 2022). There is, of course, the potential for these losses to further affect the capital base of regional banks, a problem that a deposit flight could worsen.

I doubt there is any political will in the United States to call on the fiscal authorities to step in to support banks. So, the focus will be on the Federal Reserve and FDIC, as well as other institutions providing liquidity at the moment.

Before it becomes a fiscal issue, the Fed is likely to do all it can, including cutting interest rates and stopping its quantitative tightening programme. This has already partially reversed, given the recourse to the Fed’s balance sheet used by banks facing liquidity problems last month.

02:30

Thousands of jobs at risk after UBS’ US$3.2 billion takeover of Credit Suisse

The shock to confidence in the European banking system came from the Swiss regulators rather than any fundamental reason. It was not a surprise that Credit Suisse would eventually merge with, or be sold to, another bank – or even be wound up. But the treatment of certain bondholders sent shock waves through the European credit markets. In the agreement to sell Credit Suisse to UBS, the regulators decided that a special class of bonds called additional tier 1 (AT1) bonds – which are designed to convert into equity when a lender runs into trouble – would absorb the losses ahead of equities.

This potentially turned the credit hierarchy on its head and regulators in the European Union moved quickly to reassure AT1 investors in other banks that they remain senior to equity in any resolution framework. However, the asset class has repriced and investors’ losses from the Credit Suisse writedown will be substantial.

In the short-term, there is unlikely to be much demand for any new AT1 securities while the re-pricing has made it an awfully expensive capital instrument for potential issuers.

The good news is, if one believes the regulator and if one is comfortable with European bank capital ratios, investors can still earn high yields for perpetuity on the bonds of selected high-quality European banks.

There might be little direct contagion from Credit Suisse, and UBS will be a much stronger and larger institution, as a domestic deposit-taking institution in Switzerland and in global wealth management – it should be a less risky business than investment banking.

Chris Iggo is chair of AXA Investment Managers Investment Institute and chief investment officer of AXA IM Core

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