Adam Smith in his book ‘The Wealth of the Nations’ wrote – ‘when national debts have once been accumulated to a certain degree, there is a scarce, I believe, a single instance of having been fairly and completely paid. The raising of denomination of the coin has been the most usual expedient by which a real public bankruptcy has been disguised under the appearance of pretended payment’.
Credit gives someone the power to buy. It is the catalyst that increases the spending power in an economy. Credit enables the borrower to spend before the income is earned. While the borrower gets that privilege to buy an asset or expense before she earns, she is also borrowing from her future self, thus reducing her future disposable income, and shifting her consumption from future to present. Credit has been in practice since many centuries and some texts also reveal the practice of credit and debt in ancient civilizations of India. Credit word origins from French and Latin, which means to entrust, to believe. Thus, by giving credit to someone, the giver (lender) trusts that the receiver (borrower) will return the money in future – basically a promise to pay back the dues on time. This agreement leads to the creation of debt which is serviced through payment of interest and principal in instalments. As more credit is encouraged, it created more debt. The propulsion of credit in an economy is often pushed to boost the spending power of an economy and correspondingly increases the debt burden of the economy. When the income earned in future is sufficient to cover the debt service cost, it indicates the economy is doing well. It is very important that the income generated is more than the debt service, to have a net productive impact on the economy. This can be checked through an indicator - Debt / GDP ratio, which states the debt burden of any economy.
If credit is not used for productive purposes or does not lead to an increase in GDP or rise in income levels per capita, the debt burden keeps increasing as compared to GDP in denominator. When credit is taken to invest into asset classes, it often leads to bubbles in asset prices which may not be long lasting.
If the income to service debt is insufficient, then the debt payments will be serviced through another series of fresh borrowings, which carries the risk of turning into a debt spiral, if debt keeps piling up. It is pertinent to understand if the debt of any economy is denominated in its own currency or is in foreign currency. If it is denominated in own currency, it is relatively less difficult task for policy makers to manage the debt. However, if the debt is in foreign currency, then the economy is vulnerable primarily to the exchange rate and interest rate volatility. It is thus absolutely essential that credit should be used for productive purposes – that leads to higher GDP. When an economy is down, credit is encouraged to boost spending and consumption. To encourage more credit, its service cost i.e., interest on borrowings is reduced. Thus, credit control and interest rate management tools of central banks lies at the heart of monetary policy and is resorted to manage economic activity. In my previous research paper to the December 2022 edition (link), I spoke about the economic cycles, impact on the markets and how central banks respond to the cycles. It also highlighted the impending risks that the global economy is expected to face.
We are now at the cusp of interest rate hikes that the global economies, especially the developed economies have seen at the fastest pace and at 4-decade highs. While the government and central banks generously printed money to achieve high growths post covid crash, within a matter of one year inflation started picking up. While that was viewed as transitory by central banks under the pretext of pent-up demand, the reality turned out to be the opposite. Inflation did not recede, but it got stronger, and the Russian-Ukraine conflict exacerbated the situation. With global oil and gas supply chain disrupted due to sanctions imposed on Russia by the western economies, the essential commodity prices soared to multi-year highs leading to higher inflation which many economies hadn’t witnessed in 40 years. Although the crude prices and gas prices have retreated from frightening levels post breakout of Russian-Ukraine conflict and that inflation has been softening since last few months, Fed kept continuing increasing the interest rates, as it believed that the labour markets are too tight and that need to be slowed down to bring inflation in normal range. The focus of the Fed has been on the core services sector and labour markets precisely for last few rate hike movements, with an intent of job and thus demand destruction.
Management of monetary policy and regulation of the financial system are key responsibilities of a central bank. Every central bank has a pre-defined inflation tolerance band and if the actual inflation rises or falls beyond the tolerance limits, central banks take the right set of measures to bring it under control and within tolerance limits. In case of India, target inflation is 4% and tolerance range is 2%-6%. In the case of the US, the target inflation is 2%. To lower inflation and achieve the target rate, interest rate management is one key tool adopted by central banks. As inflation touched highs of 9.1% in US, 9.2% in Europe, 7.79% in India, addressing the already missed burgeoning inflation, central banks began increasing the interest rates at one of fastest pace in history (Exhibit 2).
Central banks are the policy makers, and Banks are policy transmitters. The transmission of monetary policy happens through the network of banks in an economy. They are the lenders and the borrowers in the market. The credit availability and liquidity in an economy is controlled through the banking system. They are very vital and a strong, robust banking system with good governance can keep the economy strong even during headwinds and black swan events.
When it comes to banking, as it is primarily in the business of accepting money of depositors and deploying it in the form of loans and assets, it is important that banks have enough cash and short-term liquidity reserves. These reserves are primarily to shield the banks in case of any contingency or liquidity dry out. A liquidity problem may arise when a bank does not have access to raising capital from the market. It can also happen when the bank has invested the depositor’s money into illiquid assets or into assets which are falling in value. This may lead to profit loss and cash loss to the bank. When banks do not get new capital, fear of ‘insolvency’ in the market spurs, people run for cashing out their money from their accounts. This causes a cascading reinforcing impact on the bank causing ‘run on the bank’ and bank does not have cash to pay back to the customers. Eventually, the bank gives up and is taken control by the regulators.
2023 Interest Rate Risk and Banking Fiasco
In 2023, we were just a whisker away when the burgeoning interest rates after a decade long easy money and zero rate policy jolted the bond markets, the economy, the banks. Year 2023 began with the failure of 3 major US Banks called Silicon Valley Bank, domino impact of which could be seen in failures of two other banks in US (Signature Bank, Silvergate Capital) and one Swiss major global giant – 167-year-old behemoth, losing its existence – Credit Suisse. It is pertinent to observe that in the past there have been several periods of colossal bank failures – during the 1900s, post the 2008 crisis. Exhibit 3 presents the number of bank failures post during 2008-2023.
Silicon Valley Bank - The curious case of Interest Rate risk, Risky investments, HTM accounting, Risk Mismanagement
A state chartered commercial bank based out of Silicon Valley Bank specialized in financing and banking venture capital backed start-up companies, especially tech companies. SVB provided financing for 50% of tech companies and life sciences companies, for they supported risky ventures which banks would generally be averse of. The tech companies that received a large influx of capital post pandemic also deposited their money with the bank. The tech sector was at its peak in 2021, before the layoffs began. When we look at the balance sheet composition of the bank’s assets as of December 2022, out of total assets of $211 billion, more than 50% was invested in securities like US Treasuries, Bonds, Mortgaged backed securities (MBS). A significant portion of total assets – at 41.3% reflected HTM financial instruments. Many of these securities were illiquid in nature. If SVB were to sell and encash those securities, it would have found it difficult to find a buyer and faced massive losses. Terrible Risk mismanagement on part of the bank didn’t prompt them to take appropriate risk mitigation measures while interest rates were rising. Many reports also cite failure on part of regulators to drop the hammer on these ailing banks when necessary. It also appears as a case of regulatory oversight or ignorance as they failed to take proactive action. The bank did not have a Chief Risk Officer for most of 2022 and failed to hedge its positions against interest rate risk. (Source: Guardian).
· The Accounting Aberration: HTM – ‘Hide till Maturity’
There are different sets of GAAP rules for accounting of securities bought. Securities are bought for short-term holding, long-term holding or trading purposes. These securities are given different accounting treatment in the profit and loss account and on the balance sheet. Securities that held for longer term, till maturity are classified as ‘Held to Maturity (HTM)’. Those held for short term purposes are classified as ‘Available for Sale (AFS)’. HTM securities are held by the bank for the lifetime of the security. These HTM securities, as per accounting policy, are accounted for on an amortized cost basis. AFS, on the other side are accounted on Mark-to-market basis, which means at the period end, notional gain / loss is computed and booked to P&L account and marked to market for representation on balance sheet. 60% of the total balance sheet size was deployed in Investment securities – to the tune of $ 120 billion. Around $93 billion were invested in HTM securities. Below is the HTM and AFS composition and size of securities.
Thus, the actual losses on HTM securities are hidden and not visible unless they are sold, and actual losses are booked. SVB had 41.3% of total assets held in HTM securities, thus the profitability didn’t report actual losses on HTM securities. 80% of total HTM instruments comprised of Residential Mortgage-Backed Securities (MBS).
This takes us to our question, why in the first place did it incur losses on HTM securities – courtesy, Fed Rate hikes! As the Fed began its steepest and fastest interest rate hikes in year 2022, the bonds have faced massive losses. The 10-year US bond yields have soared from 0.5% in the year 2020 to 4.2% in 2022. Exhibit 6 and Exhibit 7 showcase the yields and bond returns on US Bonds. As evident, the rising yields have led to a 10-13% reduction in the value of bonds.
· Interest Rate Risk and Real Estate Market
What the global economy is facing today is the Interest Rate Risk. As interest rate rises, it levels up the debt service cost. It also brings down the value of several assets like bonds, equities. Interest rate risk is the risk of assets losing value as the interest rates rise. In the case of bonds, whose value is inversely related to interest rates. Bonds are issued by governments, corporates, banks etc. Bonds are backed by various collaterals, famously backed with mortgages.
As discussed in previous paragraphs, as yields increase, the bond prices fall and investors who invested in bonds who bought at zero or lower yield incur whooping losses on rising yields. If, as per accounting policy, the actual losses are not required to be accounted for on mark to market basis, they generally go under-reported and misrepresents the profitability. Apart from the Interest Rate risk, there are other risks that impacts the value of bonds as interest rates rise and risk in economy goes up and leads to acceleration in bond prices. They are– Credit Risk, Default Risk, Liquidity Risk.
As these risk factors in the market economy increase, the risk premiums go up, further pushing up the yields. When it comes to Mortgaged based securities, which are bonds backed by mortgaged assets, further loss of value of assets, increases the investor losses. As corporate earnings deteriorate, credit worthiness decreases, the risker assets command higher risk premium thus driving down the bond prices further. Bonds are generally held as no-risk or low-risk assets. Major buyers of these bonds are banks, pension funds, retirement houses, debt funds etc. When interest rates increase at a rapid pace, as happened in 2022, the value erosion leads to investor losses. These losses are not accounted for profitability purposes, until marked as AFS (Available for Sale) securities.
Coupled with the increase in the bond yields and interest rates, US Real Estate has faced a fall in the prices over last one year, thus driving down the real estate backed securities like MBS etc. US Treasuries have registered a fall of 17% in the year 2022 due to a steep rise in rates. Exhibit 8 provides trend of Real Estate in US and since 2022, it has been falling.
In the case of SVB, as 41% of assets were held in HTM securities composed of MBS, the extent of unaccounted losses was tremendous. The unrealized portion of losses on HTM portfolios were $15 billion. To raise cash, if a bank were to offload its bonds holdings in markets, it would have further led to a fall in realizable value. These HTM losses are tucked away into the footnotes of financial statements. Many financial institutions carrying bonds portfolios and exposed to riskier assets, are exposed to such losses. The Held till Maturity became inevitably ‘Hide till Maturity’.
To stay afloat, it needed immediate funding and capital, which it failed to do so. This caused a slump in its share price and drove fear in markets as depositors flocked to take their money out. This became a typical ‘run on bank’ case, where a bank already in dire of capital, fails to raise and the depositors run to withdraw their money, reinforcing, and forcing the bank to go under. SVB collapse has raised eyebrows and questions on applicability and continuance of HTM accounting on amortized basis. As HTM poses a greater risk due to under-accounting of losses on account of bond value erosion, banks having a larger portfolio of HTM securities are at risk.
· Uninsured Deposits – Risk to Depositors and Under Regulation
Another point the event has raised is Deposit Insurance. Post the 2008 crisis, the US Government increased the deposit insurance limit from $ 100000 to $ 250000. Thus, deposits with the banks are insured up to $250000 per account. If a customer has balance of more than ceiling limit, she may lose that money if the bank goes under, and government does not bail out the depositors. Deposit insurance is the government's guarantee that an account holder's money at an insured bank is safe up to a certain amount, currently $250,000 per account. Deposit insurance is provided by the Federal Deposit Insurance Corporation (FDIC), a government agency that collects fees – insurance premiums – from banks. FDIC is an independent federal agency created at the depth of the Great Depression, the greatest economic crisis of modern history. The FDIC insures deposit products, including savings and checking accounts, money market deposit accounts, and certificates of deposit. As per S&P Global database, SVB had 93.8% of its deposits uninsured. Today, there is at least $7 trillion in uninsured bank deposits in America. This dollar value is roughly three times that of Apple’s market capitalization, or about equal to 30% of U.S. GDP. Uninsured deposits are ones that exceed the $250,000 limit insured by the Federal Deposit Insurance Corporation (FDIC). They account for roughly 40% of all bank deposits. (Source: S&P Global).
Exhibit 9 presents the big banks of the US that have high uninsured deposits.
Under the pretext of being too small to be regulated, SVB sought exemption from regulations that were imposed post the 2008 crisis to keep the banks in check. The guardrails once constructed by the regulators and government to guard the financial institutions, SVB managed to overcome and circumvent by seeking exemptions from Volcker rule that regulated venture capital firms. These were circumvented through petitions and lobbies. SVB was proclaimed and powerful enough in California state as it held prime position in financing and supporting the start-ups and venture capital world which are often glamorized to foster innovation, create employment, boost economy. However, oversight and under-regulation caused the water to overflow and cause a flood. Under-regulation also enabled banks to take risky positions and less stress testings of portfolios.
Credit Suisse - Demise of 167-year-old GSIB
The case of Plunging share price, Exodus of capital and erosion of bank’s credibility.
Financial System facilitate the flow of funds from those who save to those who invest. The system runs through intermediaries comprising of financial institutions, banks, shadow banks, capital markets, money markets. The instruments issued by these institutions enables better risk allocation and diversification. Banks form an integral part of the overall financial system and for transmission of monetary policies. They hold key role to stability of the financial system. Any jitter may wreak havoc in the economy and may cause ripples across the globe. The more inter-dependent and inter-connected banks are, wider their reach is, more diverse types of businesses they are in, more critical they are to the stability and smooth running of the financial system.
Systemic risk is the type of risk that cannot be diversified. It is the risk that underlies the market and cannot be avoided in case of any unfavorable event. Systematically important institutions are those which are too important and too unaffordable to fail. If failed, it may lead to collapse of economies and long depressing times. Banks are determined as Global Systematically Important Banks (G-SIB) based on several criteria – size, cross jurisdiction activity, leverage, no substitutes, interconnectedness. On a periodic basis, FSB (Financial Stability Board) declares list of G-SIBs, which are subject to certain capital regulations. These are famously called ‘too big to fail’ and Credit Suisse was one amongst them. The Swiss Investment bank which had a global penetration and deep interconnectedness with other banks, was essential for smooth functioning of global financial system. Credit Suisse had a local Swiss bank, wealth management, investment banking and asset management operations. It had over 50,000 employees and 1.3 trillion Swiss francs in assets under management at the end of 2022 that was reduced from 1.6 trillion a year earlier. With more than 150 offices in around 50 countries, Credit Suisse is the private bank for many entrepreneurs, rich and ultra-rich individuals, and companies (Source: WSJ, Mint)
The sell-off in Credit Suisse's shares began in 2021, triggered by losses associated with the collapse of investment fund Archegos and Greensill Capital. In January 2022, the chairman resigned for breaching COVID-19 rules, just eight months after he was hired to fix the ailing bank. The new CEO appointed failed to convince investors on his strategies to revamp the bank. In February 2023, the bank confirmed that its clients had withdrawn $119 billion from the bank in the last quarter of 2022 (Source: Reuters). Credit Suisse said in its 2022 annual report the bank has identified "material weaknesses" in internal controls over financial reporting and has not yet stemmed customer outflows. Post US Banking fallouts, Credit Suisse began giving jitters. The bank had been ailing for a long time, which was reflected in its stock performance.
Due to liquidity crunch, it was looking to raise capital from its investors. Meanwhile, citing some internal issues, bond markets and Credit Default Swaps of Credit Suisse began giving red signs as the yields shot at a multi-year high. Credit Suisse’s share and CDS performance is given in Exhibit 10 & Exhibit 11.
During the week before the takeover by UBS, as Credit Suisse needed urgent funding, it’s major investor Saudi National Bank rejected to infuse fresh capital citing regulatory norms, thus panicking the equity and bond markets. Credit Suisse was given a $54 billion lifeline by the Swiss Central bank on Thursday of that week, to shore up liquidity after a slump its shares and bonds intensified fears about a global banking crisis. Being a systematically important bank, it was vital that the policy makers did not let it collapse. The Swiss government carved out a deal over weekend with UBS, another Swiss major who bought Credit Suisse in matter of two days. Before the market hours, the deal was sealed, thus saving the bank from collapsing.
The failure of the bank could be attributed to strings of scandals and frauds, frequent change in top management, multibillion dollar losses. (Source: Reuters)
Another aspect that is worth discussing here is the AT1 Bonds issuance. Post the takeover, Credit Suisse wrote off $17 billion of AT 1 bonds it has issued to its investors. That’s a complete loss to those who invested in these special categories of bonds. AT1 stands for Additional Tier 1 - denotes Capital raised by banks towards their permanent capital. Thus, treated more like Equity than Debt. These bonds get exceptional treatment where investors do not get principal back, but interest payments remain incessant, at least theoretically. Interest payments are higher thus attracting investors. Notably, they are unsecured, and they do not mature. They are treated junior to all other debts, but senior to equity, akin equity. Credit Suisse had $17B (INR 1.4 lakh crores) of AT1 Bonds on its balance sheet. These bonds have now been written off completely thus - totally worthless! AT1 Bond is $275 billion market, and this loss is the biggest ever seen. The contagion impact of AT1 bonds write off is being reported in global markets. Japanese arm of Credit Suisse, Mitsubishi had 1500 investors invested in those bonds, out of which 1300 were individuals who lost their principal investment completely. Along with the bond losses, the equity shareholders faced heavy losses.
Government Measures on the Bank Failures
· Bailing out Depositors
The US Government will not bail out the bank but has assured the depositors that they will be bailed out in complete, however investors will have to take the losses. GOV has further assured that taxpayer’s money will not be utilized for bailing out the depositors. This raises speculations on the funding of bailout packages, which narrows down to printing of money. After SVB’s fallout, 2 more banks gave up – Signature Bank and Silvergate Capital. There is yet to receive clarity on how will funding for bailout of depositors happen. It looks likely that Fed may resort to QE programs. However, inflation concerns may bring challenges to the QE program, as we have already witnessed the sharp inflation impact of money printing post covid.
· Funding to Banks by US Federal Reserve (Fed)
One option for banks to raise cash is to sell the assets / securities they are holding, however but floating those securities in market would worsen the situation more, pushing the prices downwards and taking in more losses – ‘impact cost factor’. Selling illiquid assets would further make it difficult for banks to sell those in the market. Thus, banks resorts to raising financing from external sources or through central bank’s temporary facilities or investors. To provide short term liquidity to the banks and avert a domino impact of banks fallouts, Fed provided a temporary capital facility under BTFP. It is an emergency lending facility for banks. This Bank Term Funding Program (BTFP) was created to provide additional funding to banks if there is a run on the banks. This led Fed’s balance sheet to tick upwards after its Quantitative Tightening in 2022.
While for the last many months, amid inflationary pressures, the Fed has withdrawn liquidity from the market by selling bonds from its balance sheet. (Inversely, it buys Bonds from markets to infuse new liquidity, which is famously called the Bond Buying Programme or Quantitative Easing i.e., QE). This withdrawal of liquidity through bond selling and reducing the balance sheet size of the central bank is called as - Quantitative Tightening (QT). During the pandemic, with the bonanza liquidity that Fed infused, the balance sheet ballooned from $4 trillion to $8.9 trillion. Over the last few months, balance sheet size shrunk in size by $600 billion as an inflation control measure. Post the 2023 banking crisis in US, Fed balance sheet increased by $300 billion, giving a view of QE, but it’s not. These are towards credit extensions to banks through mechanisms - details in next slide. Increase on account of Loans - includes primary, secondary, and seasonal loans and credit extended through the Paycheck Protection Program Liquidity Facility, Bank Term Funding programme (BTFP) and other credit extensions.
· US Dollar Liquidity Swap lines to other Central Banks
US Dollar liquidity swap lines are swap lines provided by US Federal Reserve improve the liquidity conditions in dollar funding markets in US and abroad by providing foreign central banks with the capacity to deliver US Dollar funding to institutions in their jurisdictions during times of market stress. During March-April, European Central Bank availed US Dollar liquidity line of $ 3.28 billion and Swiss National Bank availed $207 million. These swap lines are given on credit for a week’s time and at current US Dollar interest rate. These amounts are low as compared to the funding availed by these central banks in the past.
Leverage and Banking
Other factor that is extremely critical to banking sector is Leverage. Very nature of banking business is based on leverage. The bank lends by borrowing money, which it has to pay back to depositors or the banks from who they have borrowed. Typical leverage ratio of a bank is 12-20 times and any fall in the asset value magnifies the impact on equity and thus solvency of the bank. For example, a bank has $100000 as its own funds (equity in nature), it has taken borrowings of $20,00,000 and deployed $19,00,000 in form of loans and investment in assets or market securities. Suppose the value of total assets falls by 10% i.e., a loss of $1,90,000 – which translates to complete erosion of equity and ending with negative equity of -$90,000. Thus, leverage amplifies the impact of losses and gains. Higher the leverage of a bank, more risk it carries to any sensitivity or movement in the assets value.
Historically, financial crisis occurred on account of factors that can be encapsulated into – Assets Booms and Busts, Banking Collapses or insolvencies of financial institutions, receding confidence in financial system, Credit Crunch on account of Monetary tightening, Recession.
When the asset value falls, many banks turn insolvent. People lose confidence in the bank which leads to further withdrawal of funds from the bank, leading the bank towards a liquidity crisis. Liquidity crisis arises when there is no short-term capital or ready access to cash available with the bank, coupled with illiquid assets, although it may be profitable or having a positive equity. Insolvency crises arise when bank’s long-term continuity gets questioned due to heavy losses. Thus, liquidity is a ‘cash’ concept and solvency are a ‘profit’ concept. Many banks restrict their lending practices thus leading to credit crunch. As credit gets limited in market, it slows down the growth, leading the economy into recession. This becomes a reinforcing vicious cycle leading one thing to another.
Reiterating that current banking crisis is largely interest rate risk driven and that it is not expected to eliminate as of this moment. Fed has been adamant over keeping the interest rates higher owing to stubborn labour markets. Till the time, the interest rates hikes continue, risk of asset value erosion and consequent banking crisis remain and shall keep especially those banks on the edge that are having large HTM securities and bond holdings. Depositors for the bank who are not covered by FDIC are further exposed to risk of losing their money.
FOMC (Federal Open Market Committee) released in its minutes at end of March 2023, suggested the target range of interest rate in 4.75% - 5%, to achieve target inflation of 2% over the long run. Current inflation for US is 5.8%. FOMC minutes emphasises that US banking system is sound and resilient, and the recent developments in banking sector may result into tighter credit conditions for households and businesses, and that may weigh on economic activity, hiring and inflation. As banks face tightening, they reduce their lending rate as the degree of aversion rises. The Fed manages this activity through Reserve Ratio. Even when Fed prints large amounts of money and provides liquidity to banks, in order to prevent the money from entering into the market and avoiding inflationary pressures in economy and in asset classes, Fed raises the Reserve Ratio, thus encouraging the banks to deploy the funds with the central bank to earn higher return than what they would earn on risk-adjusted basis from lending.
Although financial crises do not repeat in same way, they generally have a host of reasons triggering the outcome. US has faced two grave most depressions – 1929 and 2008. The Roaring 20s (1920-1929) was a period of economic boom. There were massive bank failures during that decade which began the Great Depression. The bank failures began in 1921 and no of banks failed on annual basis remained below 1000 per annum till 1929. Post that, there was sporadic rise in the failures, which eventually stopped after the Banking Holiday of 1933. As banking collapses gripped the US economy, the stock market crashed in 1929.
In 2008, 164-year-old Investment Bank, mortgage-based security (MBS) under-writer - Lehman Brothers filed for bankruptcy, inviting the worst financial crisis since the Great Depression. Having a book size of $680 billion and highly leveraged by subprime mortgages with collateralised obligations running on top of another, led to one of painful episodes in the economic history. In 2008, nearly 25 commercial banks, 2 major Investment Banks - Lehman Brothers and Bear Sterns collapsed, eroding billions of dollars from financial system, losses to funds and making many citizens homeless. The commercial banks collapse began in early 2008 with 10 banks with asset size of $39.9 billion. Lehman had an exceedingly high exposure to overall real estate which was falling in value, not to forget the Commercial Real Estate exposure that Lehman carried. As bank announced billion-dollar losses in 3rd quarter of 2008, it failed to raise any investment and filed for Chapter 11 bankruptcy in October 2008. The explosive losses were amplified due to large exposure to derivatives. Immediately after Lehman collapsed, Washington Mutual, one of largest commercial banks with an asset base of $307 billion went under. It was eventually bought by J.P. Morgan Chase & Co. Between 2008-2015, a total of 520 banks failed, with a total asset base of $702 billion. Below chart indicates the US Commercial Bank failures between 2008-2023 (till date of this note), total count and asset size (excluding investment banks). Till date in 2023, 3 banks with an asset base of $340 billion failed.
The below chart indicates the movement of interest rates from 1954-2023. The shaded vertical areas represent recessionary periods. It can be observed that higher interest rate levels preceded recessionary periods and slowdown.
What lies ahead – Looming risk factors?
· Debt ceiling
Every government fund its growth-oriented spending operations through the revenue it earns through the fiscal policies including tax policies. When the revenue is not enough to fund the expenditure ambitions i.e., expenditure is more than revenue which leads to fiscal deficit. This deficit is funded through borrowings. We return to what we began this note from – Credit. The government resorts to credit driven growth. As long as the income (revenues) is more than the expenditure and debt service cost, the show goes on. As every government can borrow funds by issuing government securities, which are bought by the entire eco-system including global institutions, the nation that enjoys highest credibility can issue more debt to funds its spending. This continues till the debt limits are exhausted and the government does not have enough cash to service its debt. US government is close to this situation. US Government borrows to fund its spending programmes and foster growth. US Treasury department creates and issues the securities. These securities are debt owed by Federal government – in form of Treasury bills, notes, bonds having different maturities. There is a debt ceiling limit fixed beyond which US government cannot borrow. US currently reached $31.4 trillion debt limit in January 2023. Over last 4 decades US Debt has increased from 30% of GDP in 1980s to 130% + of GDP in 2022. This can be observed in Exhibit 1.
Treasury department has taken extra-ordinary measures to save the country from defaulting – including accounting manoeuvres to reduce the debt (source: Politico), giving the nation cushion of $800 billion. Due to the debt ceiling imposed, the government cannot borrow more to fund its cash requirements. This makes it reliant on revenue and if those are insufficient – considering the weakening earnings season of US companies – unless the debt ceilings are revised upwards or abandoned – US may default on its payments. This shall have wide repercussions, right from – spendings, public infrastructure, loss of confidence in US dollar, fall in value of bonds – this may spread further as many global economies are holding US Debt as safe haven assets.
As the global economies are attempting towards de-dollarisation of international trade, while China and India are taking the lead to place their currencies open for international trade and wider circulation, US Dollar hegemony is being challenged. These moves come from global economies as world is moving more towards de-globalisation – US money printing mania and resultant inflation, Russian Ukraine conflict and resultant rising food and energy prices – has resulted into steepest rise of interest rates by US, which has caused many countries to suffer from rising debt service cost and currency depreciation. To challenge the dependency that countries have on US Dollar, they want to reduce the autonomy that US Dollar has on their economy, especially those are import dependent and having high foreign debt.
The decision to raise the debt ceiling limits or abandon is yet to taken by Congress and the matter is divided between the widely polarised Democrats and Republicans. But, since 1917 when the debt ceiling was imposed post WW1, the ceiling has been revised or suspended more than 100 times. Thus, it is likely that policy consensus may be arrived at, thus avoiding the risk of default. This year hosts a smorgasbord of potential events that may not keep markets at ease, increasing the probability of higher volatility in equity and bond markets.
· Yield Curve Inversion
The long-term bonds carry higher yield than shorter term bonds, as long-term bonds carry higher risk than shorter term. Thus, the yield curve is upward sloping in general cases (Chart). However, there are certain circumstances when the yield curve inverts – which is when the short-term rates are higher than the long-term yields. As the short-term rates are increased by the central bank and the long-term rates remain flat or falling, the spread between the long term and short-term rates shrinks. This incentivises investors to hold cash or invest in short term securities than in long term bonds, to earn a higher yield. Yield curve inversion is stated to be pre-cursor and a leading indicator to recession. Below Chart indicates yield curve inversion and the vertical shaded areas are recessionary periods. Yield curve inversion is a widely tracked tool for checking recession signals.
While Yield curve inversion has served as accurate predictor of recession since 1960s, there is less empirical evidence as to why the association between the yield curves and recession holds. As of the date of writing this note, the US 10Y Government bond yield is 3.591%. The spread between 10Y and 2Y US bonds is -65.3 bps as a 2-year bond yields 4.244%, showing a negative yield curve.
Besides, the Credit Default Swaps of US Bonds have increased recently to touch highs as last seen during 2008 crisis. Credit Default Swaps (CDS) spread indicate the risk premium underlying the security or sovereign. As the risk of default rises, the CDS spreads increases.
· Commercial Real Estate
Commercial Real Estate loan market is $5.6 trillion in size, and it is facing risks of higher borrowing costs and weakening property valuations. Bulk of the debt was financed when the interest rates were nearing zero. These need to be re-financed now then the interest rates are at more than 5%. Regional banks, smaller in size, make up for 80% of CRE lending. With changing patterns and work behaviour post lockdown as more workforces prefer working from home, their resistance to re-join offices and preference of many companies to have 100% work from home has increased the vacancy levels of commercial spaces and US offices. The vacancy rates in 2022 are much higher than 2019, according to Moody’s. This has led to sharp and deep declines in the valuation of commercial spaces of US. As the Credit Crunch increases due to limited liquidity, banks have increased their lending standards and are stricter. This poses risk to the real estate development in the country. CRE sector relies heavily on lending and ability to look for other sources of capital are limited now. The CMBS (Commercial Mortgaged backed Securities) spread over US Treasuries has surged over 6% post banking fallouts, posing risk and threat to the bond holders and also to those smaller / regional banks having exposure.
· Banks Stress - HTM and Bond Portfolio
Till the time, Fed keeps the interest rates high and risk in financial sector remains higher, the risk premiums and bond yields stay higher. This shall cause losses on bond portfolio of banks. The Commercial Real Estate (CRE) is seen to be slowing down and is posing risk towards CRE backed bonds. Those holding these securities are exposed to any downward movement and any adverse event to cause a meltdown.
Currently, US banks are having $620 billion of unrealised losses (source: Bloomberg). These losses are good till the time they are realised by selling the bonds in the market. There is an ‘impact cost’ associated when massive quantities of securities are offloaded in the market, driving down the prices. However, these unaccounted losses deter the investor confidence and we have discussed how sentiments drive the market movements. The US government has assured the depositors of failed US banks that they will be bailed out. SVB had 93.8% of its total deposits uninsured. Likewise, as per FDIC database, out of total Domestic deposits with all banks of $17.725 trillion as at end of 2022, $10.068 trillion is insured, thus making it 58% of domestic deposits.
The increasing interest rate hikes and banking crisis driven recession is quite high for global economies. Now, it is just about time that it might knock on the doors. For many economies, it is projected that they already in a recession. As per Bloomberg report, UK, US stand to be countries with highest recession probabilities and India is expected to stay resilient and escaping recession. There are several variables that are in play with their strong inter-connectedness, thus making the job of policy makers harder. Facing de-globalisation at an increasing scale and a thin line of polarisation of West from the East is also expected to throw several challenges, while US Dollar’s hegemony is being challenged by many countries that are facing economic headwinds on account of rapid dollar appreciation in 2022 due to upward interest rate cycle. The constrained supply of oil due to reduction in production by the oil cartel organisations shall also keep the oil prices higher. This may make inflation sticky and keeps alive the possibility of interest rates hike. Fed’s vow to address the inflation by ‘whatever it takes’ has exacerbated the already fragile situation of the economies. The asset classes inflated due to money printing during pandemic, are now seeing a downturn and portfolios are getting hurt. The current crisis serves as a reminder that regulations and governance are vital, signals an alarm that interest rate risk is real, and mitigation is imminent, after almost a decade of cheap money and near to zero rates. This year is expected to be challenging for the global economy. The stock markets have rebounded from lows and the volatility index has cooled down to months low. While bond markets are in jitters and the bond volatility index gives grim outlook. Certainly, equity and bond markets are not in sync and are providing mixed signals.
All eyes on the global governments and central banks to navigate through the crises, as turbulent times lie ahead.
By Ushma Zunzavadiya, CFA
About: The author has 10+ years of experience in the field of Finance, Corporate Strategy with an Oil & Gas major. She is a qualified Chartered Accountant, Chartered Financial Analyst (CFA Institute, USA). With her sheer passion for Global Macros and Investments, she covers research on related topics.