I wrote a long piece going through the still on-going banking crisis and its plausible scenarios to Baku Dialogues. I am taking some time off and will reprint main parts of the piece here in two separate entries (with permission).
Some of the stuff most of my readers already know, but this piece will draw everything I have learned on the crisis together as a lone-standing entry. That’s why I consider that it will be helpful to many of you.
Hopefully you’re enjoying the summer!
From Baku Dialogues (reprinted with permission)
“Uh oh.” Those words very likely embody the thoughts of the chief examiner of the U.S.-based Silicon Valley Bank (SVB) on 10 March 2023, the day when that bank faced a cataclysmic run on its deposits. In just two days, SVB customers tried to pull an astonishing 87% of deposits from the bank. It is obvious that no bank can survive such an onslaught. SVB was destined to fail. And so, it did—on that very day, in fact.
Jonathan Rose, a historian and Senior Economist at the Federal Reserve Bank of Chicago, has published an eye-opening inquiry into the historical parallels of the runs on Silicon Valley Bank, Silvergate, Signature Bank, and First Republic in a recent article in the academic journal Economic Synopses. His research paints a startling picture on the scope of those runs, placing them in the context of the history of the largest depositor runs in the U.S. banking system between 1934 and 2021.
Rose found that the most destructive bank runs in the period following the Great Depression of the 1930s and before 2022 have been the runs on Continental Illinois and Trust (which commenced on 7 May 1984), Washington Mutual (8 September 2008) and Wachovia (15 September 2008). They saw a deposit outflows of 30%, 10.1%, and 4.4% of total deposits, respectively. To note, the run on Continental Illinois in 1984 was already a largely electronic one due to automated wire transfers, and thus “lightning fast.”
The outflow from Silvergate was 52% (during Q4 2022); on SVB it was 87% (10 March 2023 + expected during the next day); on Signature it was 29% (10 March 2023 + expected next day); and on First Republic it was 57% (approx. between 10-24 March). These are truly historical figures, matching those seen during the Great Depression.
Many authorities and analysts are currently pondering what this all means for banks, their deposits, and countries in general, and where we could be heading. In this essay, I will explain why authorities have caused the on-going crisis, why is it likely to get much worse, and what it implies for the world. I will conclude with a bit of unsolicited advice on how a certain category of countries, which includes Azerbaijan, can prepare and even benefit from its effects.
Short History of Banking Panics
The first recorded financial crises occurred in the Roman Empire, which had a highly sophisticated financial system. Often crises were caused by some changes in regulations (or the ‘whims’ of emperors), which in turn triggered a panic among lenders and/or borrowers. When the European banking system started to develop in the Middle Ages, banking crises, naturally, re-emerged. The most well-known from this period are probably the failures of banks owned by the Peruzzi and Bardi families, in 1343 and 1346, respectively. Their lending to England’s King Edward III as he prepared for a conflict with France that turned into the Hundred Years’ War, combined with political and economic upheavals in Florence, led to bank-crushing runs on those institutions.
The 1800s can be considered as the century of bank runs. Yale University economist Gary B. Gorton, one of the leading scholars on financial crises, calculates in his 2012 book Misunderstanding Financial Crises that the U.S. alone witnessed eight national bank runs during this period (in 1819, 1837, 1857, 1873, 1884, 1890, 1893 and 1896). Most of these coincide with the U.S. economic event most neglected by economic historians: the Long Depression (1873-1896). While researchers are still debating which of these runs should be considered as “national”, the fact remains that the nineteenth century produced a very high number of bank runs in America, not to mention elsewhere.
The largest banking crisis was, as is well-known, the Great Depression. Over 40% of banks, some 9,800 in total, failed in the United States during 1930-1934. This crisis quickly escalated into a global one, with, for example, the Austrian banking giant Credit-Anstalt failing in May 1931 and the Germany-based Danatbank failing in July 1931. Germany actually experienced a full-blown bank run during the summer of 1931. This was caused by the remnants of hyperinflation, heavy war reparations (demanded especially by France, as per the Treaty of Versailles), and the failure of creditor countries to admit the dire straits of the German economy. After the Great Depression and World War II, a long “quiet period” followed, which was abruptly broken by financial panics in the Nordic countries (most notably in Finland) and in Japan in early 1990s.
The Great Financial Crisis (2007-2012) was caused by a systematic failure of hedging of U.S. mortgage loans by the banking sector and by the imbalances caused by the EU’s common currency (the euro) to its weaker members, namely Greece, Portugal, and Spain. This needs to be explained, briefly. The reason why some economists fail to see the 2007-2009 and 2010-2012 crises as two parts of a single whole is most likely due to their lack of understanding of the nature of the crisis in Europe. The EU’s “debt” crisis of 2010-2012 was a ‘brewing’ banking crisis, which would have erupted full-on had Greece defaulted on its debts (a very high share of which was held by German and French banks) and consequently abandoned the euro as its currency. The EU “debt” crisis was put in motion as a consequence of the shock to the U.S. banking system in 2007-2009, which turned the flow of speculative capital out of the periphery of the Eurozone. For these reasons, I consider that the Great Financial Crisis runs from 2007 till 2012.
What Are Banking Crises?
To put it in slightly simplified terms, a banking crisis is an overwhelming demand of holders of bank debt to convert it into cash or other liquid forms of assets in the excess of reserves of a bank.
A bank is an exceptional entity in the sense that while, for example, the output of a tractor company is tractors, the output of a bank is debt. This makes the bank an an ‘anomaly’ in the corporate world. It follows the same accounting principles as any other corporation, but its output is a financial contract (i.e., debt). Commonly, this debt is given out as an ‘IOU,’ meaning that the bank gives a promise that whatever sum you deposit there, you get it back whenever you want. In addition to deposits, this bank debt can be in the form of bonds, derivatives, or inter-bank funding the bank has obtained from inter-bank markets. These are all liabilities to a bank, over which the holders have a claim.
Because the output of a bank are debt contracts, their holders, i.e., customers can claim them, basically, overnight, that is, depositors can withdraw their (demand) deposits almost instantly and holders of bank bonds and stocks can sell them, when the markets are open. This means that, basically, the whole “production” of a bank can collapse in a very short period of time through normal business transactions, whose level just overwhelms the resources (liquidity) of a bank. Hence the name: bank run. Basically, no other form of company has such “ticking time bomb” embedded in the very heart of its business model.
It was long thought—and is even now considered by most—that it is the job of regulators to make sure banks do not take excessive risks. This time around, however, the relevant authorities have done the exact opposite. I will explain this next.
A Crisis Caused by Authorities
The global regulatory arm of commercial banks is the Basel Committee on Banking Supervision (BCBS), which operates under the Bank of International Settlements (BIS). BIS is often called the “central bank of central banks,” as it provides guidance also for central banks.
BIS was founded in 1930, making it the oldest extant international financial institution. It first acted as trustee and agent for the international loans intended to finalize the settlement of the reparations stemming from World War I, which explains its name. Then, as now, BIS accepts deposits of a portion of the foreign exchange reserves of central banks and invest them prudently to yield a market return. The BIS also provides a forum for policy discussions and international cooperation among central banks. Therefore, the actual contemporary role of the BIS in international finance is quite hidden. Some might even say ‘well hidden,’ because we know very little about what goes on in the BIS-led discussions between central banks. The work of the Basel Committee, on the other hand, is rather public, or at least is regularly reviewed.
The Basel Committee, originally called the Committee on Banking Regulations and Supervisory Practices, is an international banking supervisory board. It was established by the central bank governors of the Group of Ten countries at the end of 1974 in the wake of serious disturbances in international currency and banking markets (notably, after the failure of Bankhaus Herstatt in West Germany, which led to a counterparty failure in currency markets). Its role at the beginning was to enhance financial stability and serve as a forum on banking supervisory matters. Later, it developed into an authority that sets regulatory guidelines for global banking supervision.
In the wake of the Great Financial Crisis, the Basel Committee released its third set of internationally agreed set of measures (i.e., rules) for banks called ‘Basel III.’ The most ground-breaking, and also, in this case, destructive concept was the establishment of something called the Liquidity Coverage Ratio (LCR), which is calculated by dividing a bank’s High Quality Liquid Assets (HQLA) with its total net cash flows over a 30-day stress period. This was meant to ensure that banks hold sufficient liquid assets to prevent central banks becoming the “lender of first resort, as stated at the time by the Group of Central Bank Governors and Heads of Supervision (GHOS), an oversight body of the Basel Committee on Banking Supervision.
The HQLA were divided into three categories: Level 1, Level 2A, and Level 2B. Level 1 assets included cash and coins, central bank reserves, and marketable securities representing claims on or guaranteed by sovereigns, central banks, and certain recognized global institutions like the International Monetary Fund (IMF). A ‘haircut’—i.e., a cut in the value of an asset in accounting—of the market value of 15% or more is subjected to Level 2A and 2B assets, in the LCR formula. After haircuts, an upper limit of 40% of the overall stock Level 2A and 2B assets in the banks’ portfolio was set. This effectively established a very strong incentive for banks to holds cash, central bank reserves, and government bonds.
While the Federal Reserve has yet to fully implement the Basel III LCR rules in the United States, it gave pre-notification of doing so in October 2013, with a proposed transition period running from January 2015 until January 2017. While the LCR still has not been fully implemented yet, it is likely that proposed transition period affected how banks handled their risk management. Moreover, the Basel II framework (the forerunner to Basel III), which was implemented in the U.S. in 2008, placed different risk-weights to bank capital with, for example, U.S. Treasuries having the lowest risk-weights. This essentially meant that Treasuries were preferred, by the authorities, as a source of bank capital, in addition to cash and central bank reserves.
Thus, because cash and coins as well as central bank reserves are a relative short supply, the U.S. banks began to acquire larger proportions of sovereign bonds. This is what SVB did, for example. That is, SVB bought U.S. Treasuries to counterbalance the risk caused by the major inflow of deposits. Effectually, SVB did what the authorities wanted, and it was not alone.
Deposit Binge, Panic, Rescue
The U.S. deposit base has changed rather drastically during the past three years. The trend-like growth of commercial banks’ demand deposits commenced around 2010. During the next ten years, they grew from around $450 billion to $1,500 billion. However, the COVID-19 lockdowns (curbing consumption), the vast amount of stimulus checks issued by the U.S. government, and the massive monetary stimulus (effectively, a bailout of the financial markets during the spring of 2020) of the Federal Reserve rocked the demand deposits in the U.S. commercial banks to over $5,000 billion in just two years.
These measures also ignited inflation, which forced the Fed to start its most aggressive hiking cycle ever in April 2022. In just little over a year, the Federal Funds Rate rose from 0.08% to over 5%. Naturally, the yields of U.S. Treasuries followed, inversely. The 20-fold rise in, for example, the yield of the 2-year Treasury note meant that the value of the underlying bond crashed. This in turn meant that those banks that had accrued them with near-zero rates (as encouraged by the relevant banking authorities), suffered heavy losses. These were labelled as “unrealized losses”, because banks obtain Treasuries as a held-to-maturity asset, which means that banks let them mature after which the Treasury returns the principal of the bond and pays the interest. Thus, they are not “actual losses” unless a bank is forced the sell the Treasury before it matures. Now, if a bank would face a deposit flee burning through its cash and easily liquified assets, it would be forced to sell the Treasuries with a considerable loss. This is what happened, for instance, to SVB. It was estimated that at the end of 2022, U.S. banks (taken as a whole) were sitting on nearly $2 trillion worth of unrealized losses. The large amount of unrealized losses was one reason why the run on SVB has spread, which forced U.S authorities to intervene, strongly.
By 12 March 2023, U.S. authorities had concluded that there was a risk of a nationwide bank run. To halt it, they devised a three-step strategy. First, there was a joint statement from the Treasury, the Federal Deposit Insurance Corporation (FDIC), and the Fed, announcing that all depositor funds (also uninsured deposits) held in SVB and Signature Bank were guaranteed. Secondly, the Federal Reserve provided $300 billion worth of liquidity into the system and announced that it will make “additional funds” available to all banks in what it called a Bank Term Funding Program (BTFP). Thirdly, in a highly exceptional move, U.S. President Joe Biden appeared on national television to assure that deposits in all American banks are safe.
Such a combination of rapid actions is truly exceptional, and it confirmed that the United States was on the verge of a catastrophic nationwide bank run.
End of part one.
Copyright: Baku Dialogues.
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