I will now continue to publish the main parts of my long piece on the banking crisis in Baku Dialogues. The first one can be found from here.
From Baku Dialogues (reprinted with permission)
True Problems Have Not Yet Emerged
The exceptional moves by the U.S. authorities quelled the panic in the U.S., while the “merger” (effectively a shotgun wedding) of UBS and Credit Suisse calmed things down in Europe. But only in the short term. Already at the end of April 2023, the crisis re-emerged with the failure of another U.S. regional lender, First Republic Bank. Its unfortunate fate provides important clues as to where the crisis is heading.
First Republic Bank had a heavy exposure to commercial real estate in metropolitan areas, including San Francisco, New York City, Boston, and Los Angeles, from which especially the first one was experiencing a deep slump in commercial real estate (it has continued unabated into the summer months). At the end of 2022, an astonishing 83% of First Republic Bank’s loan book consisted of real estate loans. Deposits accounted for 90% of the bank’s liabilities, and it had $4.760 billion worth of unrealized losses, which was some 27% of its total equity. In other words, First Republic Bank was not toppled by unrealized losses, but by its loan book. Why, one could ask, did First Republic Bank simply not borrow the money flowing out from the BTFP? Well, because it could not. The reason will become clear in the paragraphs that follow.
A 2016 paper by Natacha Postel-Vinay published in the Journal of Economic History provides an important notion from one of the most destructive bank runs during the Great Depression, or ever, namely the Chicago Panic of June 1932. Its findings are directly relevant to the present-day situation. Back then, wire transfers had already become commonplace, which means that part of the runs of that era also occurred electronically (i.e., rapidly). In her paper, Postel-Vinay shows that the size of the real estate loan portfolio was a crucial factor in determining the probability of a failure of a bank during the Chicago Panic, between 20-28 June 1932, because commercial real estate, and especially mortgages, had (have) very long contract maturities. Banks simply could not liquidate these to pay out heavy deposit outflows; as a consequence, they failed.
Small regional banks in the United States currently hold a vast majority of real estate loans (the figure is close to close to $2 trillion). In regional banks these have grown by 35% since the beginning of 2020, and by whopping 147% since bottoming out during the last week of 2011. Because real estate loans cannot be liquidated, many of these banks are likely to fail, if (or when) runs in the U.S. banking system commence. For example, First Republic Bank was able to borrow only around $13 billion from the Fed’s BTFP scheme, because it did not have any more assets to post as eligible collateral.
The cascading effect of the above is a decline in the ability of banks to lend, as deposits make up a large portion of liabilities of banks (especially regional banks). Thus growing deposit base enables the growing of the asset side of the balance sheet, including loans, and vice versa.
Credit Depression?
In the May 2023 issue of Deprcon World Economic Outlook, a monthly publication put out by my firm, GnS Economics, we explored the credit tightening currently ongoing in the U.S. We noted:
The outflow of deposits from banks started at the beginning of November [2022] (there was a notable decline already in October [2022]). At the same time, inflows to money market funds (MMFs), also accelerated. This is no surprise, as MMFs currently carry a much higher return (yield/interest) than deposits. In March [2023], the deposit-outflow accelerated into a rout, and currently [I.E., IN MAY 2023] the outflow of deposits is almost $1 trillion (year-over-year), with the vast majority (over $600 billion) exiting from the 25 largest [U.S.] banks. It should be noted that the U.S. has never seen such an ‘deposit-exodus’ since the records began (in January 1974).
While banks can and will balance the outflow of deposits with other means, like borrowing from interbank markets, such measures are only a temporary fix. This implies that as long as deposits keep flowing out of banks, their balance sheet will shrink, which will, in turn, constrain their lending. With the current outflows, the U.S. is surely already experiencing a credit contraction. However, there’s more. Again, from our May 2023 Deprcon Outlook:
Demand for C&I [commercial and industrial] loans is clearly in a state of collapse, something which previously has not been seen outside a recession or immediately after it (like in late 1991). The decline started during the last quarter [of 2022], with a drastic 21% drop of loan demand by small firms. Currently [i.e., May 2023] the reported declines are over 50% in loan demand from both small and large firms. This corresponds to the declines seen in the first quarter of 2009, that is, right after the deepest phase of the Great Financial Crisis.
This quite straightforwardly implies that the United States is already rather deep into a credit contraction, which is also the harbinger of recession. This is because a credit contraction leads to diminished economic activity due to lower levels of investments and consumption, which creates a recession, which leads to a rapid growth of loan delinquencies and defaults. This will lead to rapidly growing loan losses, causing banks to tighten lending even further. This will hurt consumption and investments, and the cycle repeats, which causes an actual credit crunch.
This time around, however, loans losses are likely to hasten the deposit outflow from banks, possibly turning into a nationwide rout. This would lead to another and more severe wave of bank runs, which would push the U.S. into an outright credit depression, where the flow of credit would seize altogether.
Scenarios, Implications
There are three basic scenarios for the ongoing banking crisis, each with its own outcome. These range from a mild recession to a repetition of the Great Depression. Crisis forecasting relies on both narratives and models, and here I present just the narratives (the models, and the methodology informing them, are proprietary).
I consider that obtaining the “best case” scenario (mild recession) requires some draconian actions from U.S. authorities. Essentially for this scenario to manifest itself, the authorities would need to stop the bank runs in their tracks as soon as the recession (most likely) re-ignites them. It is very likely that this would require the (unprecedented) imposition of a nationwide full-deposit coverage and/or a mandatory set of deposit withdrawal restrictions. Central bank digital currencies can play a role in this (more on this below). In addition, the U.S. government would need to issue a heavy fiscal stimulus package in the range of trillions of dollars and the Federal Reserve would need to enact another Quantitative Easing (QE) program to support the financial markets. If done right and quickly, these measures should ensure that the U.S. would experience only a mild recession. However, the U.S. banking system would effectively become nationalized in the process, with likely serious long-term consequences.
In the second scenario, the U.S. would face a nationwide bank run. Several hundreds of banks would fail, but the authorities would intervene in such a way as to clear the banking sector with takeovers, forced mergers, and re-capitalization. The Federal Reserve would start to aggressively cut interest rates, which would help the economy. The Fed would also restart QE and possibly create new lending programs to help the banks. These could possibly also include a co-ordinated program with Fannie Mae and Freddie Mac to securitize mortgage loans of banks and to either sell them or use them as collateral in the BTFP. The U.S. would , most likely, experience a somewhat deep recession, but avoid a depression. However, unemployment would rise notably and the availability of credit would become heavily restricted.
In the third scenario, the U.S. authorities would be unsuccessful in stemming the banking panic. Loans losses, illiquidity, and massive deposit outflows would lead to a failure of thousands of banks, which would cause a credit depression. Mass bankruptcies, skyrocketing unemployment, and social unrest would follow. The U.S. could even default on its sovereign debt. Global financial markets would crash, the flow of global credit would cease, the Eurozone would fracture, pushing the world to never-before-seen currency crisis.. Global freight would grind to a halt, because banks could not underwrite and provide funding for freight agreements. Governments would need to step in, but many governments would default to their high debt loads. Global trade would collapse taking the world economy with it. Another Great Depression (maybe even the ‘Greatest Depression’) would invariably emerge.
Currently, I consider the middle, or second, scenario to be the most likely one. This is because it would follow the “bail-in” principle, whereby banks will not be saved in their totality, but just some part of the depositors (the reasoning here is political and has to do with domestic U.S. politics). For similar reasons, the third scenario—i.e., another Great Depression—is, in my view, the second-most likely scenario, because bank runs may easily escalate in the current environment. Thus, we may end up seeing all three scenarios coming to pass. This could mean, for instance, that first there will be some bank failures, which U.S. officials will allow, and then this would lead to nationwide bank runs, which would crush the economy, and eventually lead to the imposition of some form of financial lockdown, including deposit withdrawal limits and extended bank holidays.
It should be noted that, if the crisis in the U.S. follows one of the two latter, more sinister forms, the European banking sector would likely have its day of reckoning, too. If this were to come to pass, the European Union would be faced with only two options concerning its common currency, the euro: either it fractures, or the EU moves into full federalization mode. The first one would include several countries exiting the common currency or its full dismantling. The second one implies the imposed establishment of what would effectually be a Eurozone Finance Ministry and corresponding “federal” EU taxation powers, including a massive new bond issuance (in the range of 2-4 trillion euros).
Naturally, this topic would require its own article. At present, it is also nearly impossible to assess which of these is more likely occur, but some informed forecasting suggests that European leaders will at least first push for full federalization, because there is simply too much political capital tied to the perpetuation of the euro. It’s good also to note that the Eurozone is already in a technical recession, as it has seen two consecutive negative GDP growth prints.
CBDC Domination?
The question now becomes what the central banks may be willing to do when faced with a deep enough banking crisis. The answer may lie in so-called central bank digital currencies (CBDCs).
Central bank money is at the core of modern financial systems. It is comprised of physical cash in circulation and central bank reserves—i.e., the deposits of financial institutions in the central bank. A CBDC would create another layer of central bank money. In its strictest form, a CBDC is a digital payment instrument that is denominated in the national unit of account, or currency, which is also a direct liability of the central bank. Essentially, a CBDC can take two forms. It can be a central bank issued digital currency (retail CBDC) or a central bank-backed digital currency now called a ‘synthetic’ CBDC (sCBDC).
A CBDC is ‘synthetic’ when it is backed by deposits (reserves) at the central bank. Another name for this is wholesale CBDC. The basic mechanism of a sCBDC is when private sector payment service providers issue liabilities matched by funds (reserves) held at the central bank. The private issuers of digital currencies would act as intermediaries between the central bank and end users like consumers and firms. Regardless of whether the liabilities of the providers would be fully matched by funds held at the central bank, the end users would not hold a claim on the central bank.
A CBDC is considered to be retail, when it is a widely acceptable digital form of fiat money that can act as a legal tender, or not; it can either be account- or token-based. The former would be considered intangible property and it would involve the transfer of a claim between accounts and would resemble a bank account transfer, with the distinction that all accounts would remain within the central bank. In the latter there would be a transfer of a token between wallets. Settling transactions using a token-CBDC (a tangible property) would require external verification of the tokens, which would imply that anonymity, like with transfers in cash, could not be guaranteed. In each case, the holder of a CBDC would have a claim over the central bank. Another way of putting this is that we all could have an account at the central bank.
The instauration of both systems—i.e., wholesale and a retail CBDC—would alter the banking system in a radical way. First, fractional reserve banks, where banks hold only fraction of their liabilities and assets are covered by capital or CB reserves, would come under pressure. Banks would be likely to lose some customers, pushing them to seek more wholesale funding, such as funding from commercial credit markets like state and local municipalities and brokered deposits. Banks could be forced to raise interest rates on deposits, which would reduce their profits.
A retail CBDC would be very detrimental for the banking system. This is because it is the role of a central bank to monitor and regulate banks and to act as a “lender of last resort” in banking panics and runs. With the issuance of a CBDC, a central bank would become a competitor of commercial banks. It is hard not to avoid the conclusion that this would corrupt the whole financial system. Commercial banks would be forced to compete with the more secure CBDC with higher interest rates, and even if the CBDC would be non-interest bearing, it would still offer safety (especially in a zero or negative interest rate environment). Banks would thus compete against the CBDC by issuing higher deposit rates, while they would be at the mercy of central bankers concerning regulation and guidelines. Serious questions can be raised whether central bankers could act in an even-handed way in this setup.
However, the biggest problems would arise in a banking crisis. Let’s assume that a country would enact sCBDCs as a countermeasure. Because their holders would be fully covered by central bank reserves (unlike fractional reserve banks), the existence of sCBDCs could easily worsen a potential run on banks, thus making a banking crisis worse. Essentially, there would be only one way to fix this, that is, to move to the retail CBDC.
If the central bank has the backing of a fiscal authority, as generally is the case, it can provide banking services—deposits—backed by the taxing power of a government. In this situation, with the retail CBDC, the central bank would offer superior deposit safety in a banking crisis. Thus, if consumers believed that a commercial bank run is imminent, depositors would inevitably move their deposits to the safety of a central bank. While the central bank would probably lend them back to commercial banks (because otherwise the whole banking system would simply collapse), it would effectively gain control over lending of the commercial banks. In that case, commercial banks would turn into mere retail branches of the central bank. A flight from commercial banks to the safety of the CBDC could also be countered only with strict deposit limits to the central bank. It is highly questionable whether such limits could be maintained in a banking crisis as that same crisis would, almost certainly, foster political pressure to open the balance sheet of the central bank with a CBDC to all.
Alas, in the worst-case scenario outlined above, the introduction of CBDCs would lead to a situation in which the banking system would effectually consist of just one bank: the central bank. The extremely serious implications of such a system need not to be emphasized further. Even in their ‘mildest’ form, the introduction of CBDCs would pose an existential threat to commercial banks and thus on financial freedom.
Conclusions
I have become rather skeptical towards global governance organizations of late, and have recommended that countries stay out of IMF programs, and so on. However, this would require that a country’s economy be made “crisis proof” before the crisis hits. Essentially, this implies low indebtedness of households, corporations, and the government, limited foreign financial exposure, sufficient gold reserves in the central bank, and prudent oversight of the banking sector. Many countries have not done this, which means that they are likely to be forced to ask for IMF support in the near future.
The coming, or, more precisely, the ongoing crisis that will most likely re-appear shortly in a more destructive form is likely to reshape the global economic structures in a dramatic way. The biggest losers are likely to be some of the world’s largest economies: the U.S., the EU, and possibly also China. Their economic “engines” have been pushed to their respective limits, and some form of breaking up is inevitable. However, what they may lose will become available for other countries to gain.
When a financial system crumbles, people and countries resort to necessities. Survival, quite naturally, becomes the main issue. In such a situation, resource rich nations like Azerbaijan have a natural upper hand. Playing it correctly requires that such countries take measures to prevent their economies from being pulled under by those that are in the process of failing. Thus, when the crisis re-emerges, it will be imperative for such countries to cut without hesitation the toxic aspects of financial ties with the U.S., the EU, and possibly even China.
This will require the formulation of prudent national strategies to manage, first, the possible outflow of “hot money” (mostly through capital controls), second, currency and foreign exchange issues (especially if the EU is sucked into an epic currency crisis), and third, the country’s positioning in the context of the re-forming of global economic structures. Grouping with like-minded countries would be likely to establish important synergies, particularly if the Western bloc takes what would likely represent a Dystopian turn through the issuance of CBDCs.
Major crises have always represented opportunities for the brave-hearted, the prudent, and the prepared. If the ongoing banking crisis takes the sort of sinister turn outlined in this essay, then it will come to be seen as biggest reshuffling of the global economic and political order since the ‘Great War’ and the 1930s. This would, in turn, form the basis for the execution of a truly strategic opportunity for those states that provide global economic necessities like energy, minerals, and food to fill in the void, become economic safe havens, and secure sustainable prosperity for their respective populations. The time to start planning for such a contingency is now.
Copyright: Baku Dialogues.
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