The paths of evolution of the banking crisis…

• 31-Mar-23
• admin

Photo by nappy: https://www.pexels.com/photo/man-reading-newspaper-while-sitting-near-table-with-smartphone-and-cup-935979/

Is the banking crisis over? All the authorities say it is. But given what has happened in the last few days, it is possible to argue it has not. Let us examine it to see if a case can be made for it to be declared it’s over, or to argue that it’s got a long way to go.

There is indeed a case to be optimistic. The US Federal Reserve continued to increase interest rates in the last week, after the three banks in the US went under. The positive way to read this event is that the US government is quite sure that if it went ahead to raise rates, the adverse impact of this move would not trigger a continued run on banks.

Biden was out in front to take credit. According to CNN, he said his administration has done a “pretty damn good job” working to resolve the banking crisis and said he thought it will “take a little while for things to just calm down.” Of course, he would say that. But did he admit to pumping the economy with so much money during the New Monetary Theory fiscal expansion that the excess money went into the banking system forcing banks to deal with hugely expanded liabilities which required unplanned and aggressive asset expansion? Did he also admit to causing the 40-year record inflation that followed the huge expansion of the money supply, and his foreign policies that disrupted global supply chains and which led to bonds going into a collapse which blew a hole in the banks’ balance sheets.

Of course he didn’t.

In fact, he even said, as reported by the same pro-Administration CNN report, “I don’t see anything on the horizon that’s about to explode but I do understand there’s an unease about this and these midsize banks have to be able to survive and I think they’ll be able to do that” citing the policy that the Federal Deposit Insurance Corporation will use the power it has to “guarantee those loans above $250K like they did already.”

That’s Biden, without even giving a passing nod to the moral hazard issues that his Administration will face when more banks come under pressure. This is the same type of empty promise given to the Ukrainians that they will get support “as long as it takes”. As it turns out, NATO has run out of supplies to provide to Kyiv, and those poor fellas on the frontline are facing an ammo shortage as the Russians prove to be far better equipped. This is the nature of Biden’s presidency, marked by overestimation of his own capabilities and ultimately an inability to keep to its promises.

And that’s the optimistic interpretation of the banking events.

 

If Biden is wrong, then more banks will fail. In his promise, Biden did not say that the government will save the banks. They will only save the depositors. As we have already seen in the case of Credit Suisse, the banks can still go under even if the depositors are kept whole. It would just be a limited form of bailout, and not in the way which happened after the 2008 crisis when the banks were saved by zero interest rates, allowing them to rebuild their balance sheets.

In my humble opinion, there is still a lot more work to be done, for the current banking crisis not to worsen to the extent that happened between 2008-2012. I am not the only one who thinks so. Here is an article in USA Today:

SVB, Signature Bank collapse puts Joe Biden's leadership to the test (usatoday.com)

 

But while guaranteeing all depositors will be an effective solution to the problem of a run on the banks, as I said in my blog last week, it is not the end of all problems. The run on deposits has been contained. That’s true. But there is still the problem of the gaping hole between asset values and liability values on the balance sheets of the medium sized banks in the country. And more importantly, even the contagion of fear, rather than the contagion of failure (not exactly the same thing), will lead to a slowdown in economic activity as we can see below:

How the Banking Crisis could ripple through the economy
How the banking crisis could ripple through the economy (axios.com)

 

Alright…seems like we are dealing with too much information, too much analysis here…
Let’s summarise the above as follows:

1) There is still a problem, but not the one of depositors pulling out of smaller banks or what is known as the classic bank run. That has been solved, but with the US government taking on the moral hazard of guaranteeing all deposits, it will create new problems in the future when another badly run bank keels;

2) Even as of today, the need to nip the contagion of fear will lead to the new problem of tightening credit conditions as discussed above by Courtney Brown in the Axios article, which should have a dampening effect on the economy.

3) The shrinking of the asset side for these banks will imply a shrinking demand for US Treasury bonds, which in the face of declining Treasuries demand everywhere due to de-dollarization, will lead to increasing difficulty to fund the budget deficit.

4) The inflation problem cannot be solved unless Problem 2 gets so bad that the entire economy tanks. But that way of solving inflation is called a hard landing.

 

These are all serious problems that need to be solved but won’t be in the current circumstances.

And the above is just the optimistic outlook.

What is the pessimistic outlook? That’s when the guarantee to bail out the depositors don’t save the banks, ie exactly what happened at Credit Suisse.

We can all remember that when the Swiss regulators tried to save Credit Suisse, they also extended them a 50 billion SFR line of credit. If that could save Credit Suisse, it would. But it didn’t. The slide continued, not because depositors pulled out but because shareholders did. The biggest investor in CS, which was the Saudi National Bank, said “absolutely not” to the question of whether it would invest further to replenish the bank’s capital and it emphatically denied any plans to do that. So that’s the other way American banks can go under. In case you haven’t got it, here are the two ways a bank can go bankrupt :
                 1) The bank loses all its deposits. like in the case of SVB; or
                 2) The bank loses all its capital, like in the case of CS.

In a bank run, it is the first that occurs when the bank loses all its liabilities. In the failure of CS, it is the latter which caused it to fail so that the regulators had to merge a sound bank to the failing bank. This is also what I call the Japanese bank problem which is when the bank loses all its assets, through bad loans and lousy investments and the bank cannot exist anymore.

In all that Biden and his administration’s officials including Janet Yellen have done, he has only given the assurance that they will assure depositors to not worry about getting their deposits back. Indeed, that is a bigger problem to solve. The amount of deposits is likely to be many times (probably in excess of 20 times) the amount of capital which a bank has. So yes, it is critical to solve the bigger problem immediately. But if the smaller amount, ie the capital, is also lost, the bank cannot function either. We have seen how CS disappeared in one single day. If we are kind, we can say that this (loss of capital) will not happen to banks in the US in the next two years, but it does not rule out the possibility that the banking system can fail over a period of some twenty years, as we have seen in the Japanese debacle during the period of 1990 – 2012. The two problems are completely different and solving one does not necessarily solve the other.

In my previous commentaries, I had agreed that the tools used by the US authorities would be effective to solve the no-confidence deposit flight problem. I was right. But the same tools did not work in Switzerland. Those were good tools that were applied to the CS problem and yet the bank went down.

That’s why I have not said that I have confidence that the US government can solve the second problem of banks losing their capital as the economy weakens in the months ahead.

What exactly do I mean?

Let’s face it. J Powell has been so obsessed that he wants to own the legacy of being Volcker 2 as resolute inflation fighter that in the face of the still shaky banks, he continued to push ahead with another ¼ point rate hike and refusing to say when this will stop. Unless he brings the interest rate regime to zero, as the previous Chairman of the Fed, Ben Bernanke, did in the years following 2008, the lack of capital problem is not over. When it is time to follow in the footsteps of Bernanke, Powell sticks to following Volcker. I think this is a grievous misjudgement of the economic situation. He cites that employment is still strong, but I don’t know if he needs to change his spectacles in reading the data because the unemployment in the tech and banking sectors have been bad for some months now and are obviously going to get worse with the collapse of SVB. Can the past interest rate hikes and the new ones cause the two best sectors of the US economy to weaken further and threaten the entire economy? I would put it at even chance.

 

The worst scenario in my mind is therefore the enactment of the Japanese problem in America, updated thirty years. When it happened, Japan was riding the crest of economic prosperity with the Nikkei reaching 40,000, and a handkerchief dropped on a Ginza payment would cover $20,000 worth of real estate value (yes, I heard that analogy way back then). Who would have thought that when the Japanese economy reacted to interest rate hikes brought about by the Bank of Japan in 1990, the economy would slump for 20 years, and in that period, brought down ten of the largest banks in the world, and left only three no-longer-the-largest banks still standing. Worse still, the deflation that consumed Japan led to 9 years of Abenomics, a program launched by Prime Minister Abe aimed at ending the deflation which continued for nearly 20 years, focusing on massive monetary stimulus to build up self-sustaining expectations of moderate inflation. Abenomics was expected to be a turning point.
Has Abenomics worked? Not really, when you deflate a malicious balloon, it will probably go limp forever and land in the sea…It might have been better to just let the innocent balloon float away. The Japanese economy is still struggling at a growth rate of 1-2 percent.
Here is an analysis of why the Japanese economy has now experienced thirty years of inadequate growth:

Abenomics: The Reasons It Fell Short as Economic Policy: 

Abenomics: The Reasons It Fell Short As Economic Policy | Nippon.com

So what’s my point here?

Here are my updated thoughts on the banking crisis and the directions over which it may evolve:

 

Saving depositors do not necessarily solve all the problems. The solutions that the Biden Administration has pronounced deal with a single aspect of the crisis. That is the problem of bank runs. Yes, I don’t doubt they have solved this problem. But there are many other problems to solve, including the survivability of the banks from losses due to declining capital arising from bad loans in a lousy economy. That was the problem of the lost decades in Japan which eventually shrunk the banking sector significantly and is continuing to drag on the economy.

 

If the US also enters into two decades on pathetic growth, as the high interest rates that are still being relied upon by the Fed Reserve to shrink inflation will do, then the policy options available to new people in future Administrations will be very limited. If deflation latches on to the US economy, then economic behaviour may end up like in Japan. Inflation like the Chinese meteorological balloon, once brought down cannot rise again. Japan was, and is still exactly like that. From the massive asset inflation suffered in the 1980s when stock and property prices were in the stratosphere, after that was collapsed, the economy went the other way and suffered decades of deflation which hindered growth.

 

And Japan is different from America. Japan is a high savings economy and even in its deflation, the standard of living was not low. People just spent savings. In America, that will not happen. Most families have negative savings, ie they owe money everywhere – student loans, mortgages, credit cards. Too many small businesses rely on loans. If the inflation ends and the economic buoyancy is deflated, the ability to spend spirals downwards very quickly and the economy will slow much faster than Japan did. The banks will not fail from the bank run problem. They will be impacted by the slowing loan activity, bad loans and inevitably some will fail. This will compound the weakening economy and lead to a period of slow or no growth in the US economy. We don’t want to get there.

 

As such, my fear about the banking crisis is not another SVB. Nor even a CS. I am thinking we may get a slow drawn-out death like we saw in Japan between 1990 and 2010. But rolling out faster than it did in Japan due to the lack of savings to cushion the fall.
If that happens, the global economic and geopolitical implications will be staggering.

 

By:

Wai Cheong

Investment Committee

 

The writer has been in financial services for more than forty years. He graduated with First Class Honours in Economics and Statistics, winning a prize in 1976 for being top student for the whole university in his year. He also holds an MBA with Honors from the University of Chicago. He is a Chartered Financial Analyst.