The anatomy of a financial crisis
Destructive bank runs, and how they come to be
On Friday, we will start a series on how to prepare for the looming banking crisis (for paid subscribers only). It will cover also other economic crises.
On Saturday, 1 October, we warned on the possibility of a new global banking crisis. Like we have detailed before, it’s nearly impossible to exactly time the onset of any crisis, but this applies especially to a banking crisis, because it will be kept ‘under the wraps’ until the very moment it erupts, by becoming public.
Recently is has been almost nearly impossible to track stress, e.g., in the inter-bank markets, as most of the stress gauges, like Libor and the TED spread are being manipulated (latter especially by the Federal Reserve). They are clearly elevated now. Credit default swaps also offer some information, but currently the most important gauges are probably the stock prices of banks (see below). They have been trending downwards since around late 2020, and some banks have seen their stock prices fall like stones.
Thus, as explained in the warning, we currently have to rely on a complex combination of information sources to assess the likelihood of the onset of a banking crisis. On Saturday, we considered that the information we had received warranted the issuance of a warning.
But how banking crises come to be? All begins with the fragility of the banking system.
Fragility
If a banking system is sound and robust, it can usually withstand financial and economic shocks. But a banking system may be fragile.
Usually this is due to high leverage levels, where banks have either lent aggressively or carry risky financial investments on their balance sheets—usually both. Banks can also have a weak financial position, with chronically low profitability and insufficient reserves.
As we have explained earlier, this is exactly the state the European banking sector finds itself in.[1] You can find a more detailed explanation on the ‘dire straits’ of the European banking sector also from the Twitter thread of our CEO, Tuomas Malinen.
The ‘trigger’
The onset of a financial crisis requires a trigger. The most common is a recession or the expectation of recession among consumers and investors.
Recession leads to diminished income and defaults by both corporations and households, while expectations may turn corporations and investors to shy away from investing creating a recession in the process. This increases the share of non-performing loans in bank loan portfolios, reducing the value of loan collateral and increasing bank risks and capital needs.
As write-downs and losses increase, mistrust among other banks and depositors and investors does as well. The bank’s share price will usually start to reflect this.
If suspicion spreads, banks will be apprehensive about counterparty risk and will be unwilling to lend to one another even on an overnight basis. If allowed to continue, this will have a calamitous impact on liquidity in money markets. In the worst case, possibly fueled by rumors and insider information, a bank run will ensue, where depositors try to withdraw their money suddenly and simultaneously.
In years past, depositors would queue outside of bank offices to obtain cash. Now withdrawals are largely electronic. At the same time, the bank’s investors and institutional counterparties rush to lower their exposure by frantically selling its stocks and bonds as well as derivatives and other interbank liabilities.
If this continues, trust in the bank is broken, and it fails. Growing speculation about the financial health of both sound and unsound banks, combined with funding issues, eventually triggers a system-wide banking crisis.
In history, there have been many different triggers for financial calamity.
The trigger for the Great Depression of the 1930s was a recession, which first crashed the U.S. stock market in October 1929 and then started the banking crisis in October 1930. The financial crisis of Japan in the early 1990s started from an asset market crash in 1990, while the banking crisis of Finland, occurring at the same time, got ignited from the collapse of real estate and assets markets as well as that of her main trading the Soviet Union.
The most recent Global Financial Crisis had several triggers. These included the collapse of the “High-Grade Structured Credit Strategies Enhanced Leverage Fund” sponsored by investment bank Bear Stearns in June 2007, and ultimately the collapse of the venerable investment bank Lehman Brothers on 14 September 2008.[2]
Response of the authorities
What follows the initiation of a banking crisis—which often starts with just one bank—is dependent on the general condition of the banking sector and the response of authorities.
Bank regulators can take over the failing bank, ensure the payment of deposit guarantees, and arrange for the merger or acquisition of the ailing bank by a stronger financial institution. This well-established process provides that bank customers—depositors and borrowers—are protected while equity owners, management, and some, or even all, creditors rightly bear the losses.
A central bank will usually provide liquidity to facilitate this. If the problems in the banking sector are limited to one bank, such measures may be sufficient to stem the panic.
However, if the banking sector as a whole is compromised or suffering from a significant enough economic shock, even sound policies may not be enough to cover losses without hurting depositors, as happened in the Cypriot crisis. Currently, this may well be the case with central and southern European banks, in which case a broader banking crisis is likely to start there.
What happens in a banking crisis?
In a banking crisis, credit will become restricted and credit lines are likely to be withdrawn—especially those to enterprises.
In the worst case, authorities will be able to rescue only certain banks or only save depositors, which occurred in Iceland in 2008/2009.[3] When the banking sector collapses, it means that the economy faces a serious credit depression, where the availability of credit become diminished to a significant degree.
When the banking crisis is global, as it will be this time around, access to credit will be restricted globally, with hedging activity sharply curtailed as a result. For example, from 2007 to 2008, global gross capital flows plunged by 90 percent. The availability of so-called “freight derivatives”, which are used by end-users (e.g., ship owners and grain houses) and suppliers (e.g., international trading companies) to mitigate the risk of shipments,[4] and lending to freighters may face a collapse.
This would mean a serious reduction in, or even a complete halt to global freight activity. While it’s impossible to evaluate, precisely, how serious the impact of a collapse in the availability of these derivatives and lending would have on global freight, we have to assume that it would be large, because manufacturers will not ship without adequate insurance.
Other industrial sectors will also naturally be affected by the ‘credit freeze’.
What you need to be prepared for?
In the case of a global financial crisis, we therefore have to be prepared for:
1) Collapse of asset markets.
2) Collapse in global availability of credit and banking services.
3) Collapse in global demand.
4) Collapse of global freight.
5) In the worst case, the collapse of the global financial system (a global “systemic crisis”).
We will go through how to prepare for these in the forthcoming posts.
[1] See, for example, Q-Review 3/2019 or Q-Review 4/2019.
[2] The first failures of the mortgage lenders occurred already in January 2007. See, e.g., Tooze (2018): Crashed: How a Decade of Financial Crises Changed the World.
[3] Icelandic banks had grown to monstrous size with their assets passing 900% of the GDP of Iceland.
[4] See, e.g., Investopedia.
Disclaimer:
The information contained herein is current as at the date of this entry. The information presented here is considered reliable, but its accuracy is not guaranteed. Changes may occur in the circumstances after the date of this entry and the information contained in this post may not hold true in the future.
No information contained in this entry should be construed as investment advice. Readers should always consult their own personal financial or investment advisor before making any investment decision, and readers using this post do so solely at their own risk. Readers must make an independent assessment of the risks involved and of the legal, tax, business, financial or other consequences of their actions. GnS Economics nor Tuomas Malinen cannot be held i) responsible for any decision taken, act or omission; or ii) liable for damages caused by such measures.