The anatomy of a financial crisis (update)
Destructive bank runs, and how they come to be
A new global financial crisis started on the 28th of September 2022 with the near-collapse of the British pension funds (see the post by our CEO Tuomas Malinen for a more detailed explanation). However, it took nearly six months to become visible for the general populace in the form of the collapses of U.S. based Silicon Valley Bank (SVB) and Signature Bank, and now with the collapse of the First Republic Bank.
The way these banks collapsed was a reminder of an era where bank runs, i.e. people physically queuing to withdraw their deposits from a bank, were frequent. Many of those now alive have no recollection of such an era with slow and rudimentary payments systems. By contrast, for example, the global (or “great”) financial crisis (GFC) of 2007-2008 was a ‘silent bank run’, where financial institutions using more developed payments systems rapidly ran on the liabilities of other financial institutions. It became visible to general public only through the collapse of the venerable investment bank Lehman Brothers on the 14 September, 2008.
To educate people on the era we have entered, we re-publish this (updated) entry going through some of the typical characteristics, or the “anatomy”, of a financial crisis. If you want to understand the extent of the current crisis, please see our Deprcon Special Issue and the lecture series by Tuomas Malinen. The emergence of a banking crisis always starts with some fragility in the banking system, the precise nature of which is often only understood once the crisis is under way.
Fragility
If a banking system is sound and robust, it can usually withstand financial and economic shocks. But a banking system may be fragile, for a wide variety of reasons.
Usually this is due to high leverage or risk levels. Banks have either invested or lent using a large amount of borrowed funds, or they have lent aggressively, carrying a large amount of 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 However, now also the U.S. banking system has turned fragile, but that has more to do with the very rapid growth of deposits than leverage.
The difference between Europe and the U.S. is that, while they face a increased risk of a nation-/region-wide bank runs, the characteristics of the runs would most likely differ. The U.S. banking system is threatened by a classical run on the deposits of banks, while the European system is threatened by a ‘silent run’, where financial institutions want to get rid of (run on) different forms of bank debt, like bonds, stocks and interbank liabilities, of a bank. These have rather different characteristics, but they both are equally destructive.
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, but basically any event that breaks the trust of holders of bank debt (like deposits and other forms of bank debt) can ignite a run. With e.g. the SVB, the trigger seems to have been the failed capital acquisition and poor communication, which broke the trust of depositors for the bank to be able to honor its liabilities. The worrying thing for the U.S. system is that recession, which usually acts as the trigger, has yet to arrive.
Recession leads to diminished income and defaults by both corporations and households, while expectations may turn corporations and investors away from investing, creating a deeper recession (depression) in the process. This increases the share of non-performing loans in bank loan portfolios, reduces the value of loan collateral and, if sufficiently wide-spread, creates a re-capitalization need fora sizable part of the banking sector. As write-downs and losses multiply, mistrust among other banks and depositors and investors can grow quite rapidly. The bank’s share price will usually start to reflect this.
If suspicion spreads, banks will easily become apprehensive about counterparty risk and will be unwilling to lend to one another even on an overnight basis. If allowed to continue, this will rapidly have a calamitous impact on liquidity in intra-bank money markets. In the worst case, possibly fueled by rumors and alleged insider information, a bank run, either ‘silent’ or ‘normal’, will ensue.
In years past, depositors would queue outside of bank offices to obtain physical cash (or even before that: precious metals). 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 2007-2008 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
With the SVB, we saw an over-whelming (mostly) digital run on the deposits. This means that depositors “run” to the bank from their computers, laptops and phones. The magnitude was truly devastating, as depositors tried to withdraw 81%(!!) of deposits in just three days.3 Not a single bank can survive such an onslaught. Just imagine a corporation losing 81% of its balance sheet in just two-three days. Collapse is inevitable.
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 ensures 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 against good collateral 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, where depositor bail-ins were enacted.
At times the central bank may have to intervene massively. For instance, during part of the GFC in Europe, the interbank market was virtually nonfunctional. Banks covered their short-term liquidity needs not by bilateral lending but by credits from the central bank – just to keep safe.
After the collapse of SVB and Signature Bank, U.S. authorities took some truly exceptional measures to stop the runs becoming nationwide. First, there was a joint statement from the Treasury, the FDIC and the Fed, announcing that all depositor funds (also uninsured deposits) of the SPV and the 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 a Bank Term Funding Program. Thirdly, in a highly exceptional move (effectively confirming that there was a risk of a major run on U.S. banks) President Biden appeared on national television to assure that deposits in the U.S. banks are safe.
In Europe, actions towards the crisis, ignited by the collapse of SVB and Signature bank, were drastic also. First, Credit Suisse announced it will access the Swiss National Bank’s (SNB) Covered Loan Facility as well as a short-term liquidity facility of up to approximately CHF 50 billion in aggregate. This was not enough, and on 19 March it was announced that UBS bank buys Credit Suisse with $3.3 billion. CEO Urban Angehrn of The Swiss Financial Market Supervisory Authority, FINMA, announced that the whole Swiss banking system would have faced a risk of a run, if Credit Suisse would have been allowed to fail. The SNB ‘sweetened the deal’ with granting UBS and Credit Suisse a liquidity assistance loan with total amount of up to CHF 100 billion under privileged creditor status in bankruptcy. Moreover, SNB provided Credit Suisse a additional liquidity assistance loan of up to CHF 100 billion backed by a federal default guarantee. The Swiss federal government also provided a loss guarantee of maximum of $9.7 billion. In addition, the Federal Reserve, with other major central banks, announced opening up daily USD-swap lines for the first time since the Corona-panic (spring 2020).
From historical context, the actions taken by the U.S. and European (Swiss) authorities were extremely rare. According to the database compiled by Andrew Metrick and Paul Schmelzing, only three of the total of 57 banking crises since 1870 saw the combination of account guarantees, emergency lending (BTFP and discount window of the Fed), private sector involvement (deposit of $30 billion to First Republic Bank by 11 leading U.S. financial institutions) and private sector bail-in (nullification of AT1 bond holders of the Credit Suisse). Thus, in historical context, measures taken that strongly suggest the current crisis is ‘systemic’.
What happens in a banking crisis?
In a banking crisis, credit to the public 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 domestic depositors, which occurred in Iceland in 2008/2009.4 When the banking sector collapses, it means that the economy faces a serious credit depression, where the availability of credit becomes diminished to a significant degree.
When the banking crisis is global, as it is now, again, 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,5 and lending to freighters may face a collapse. In the worst case, 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 be directly affected by any freight difficulties and will also naturally be affected in other ways by the ‘credit freeze’.
What you need to be prepared for?
At the time of writing, the Global Financial Crisis 2.0 has resurfaced with the failure of First Republic Bank and with its takeover by J.P. Morgan Chase. Now, the crisis will probably subdue again for a while, or not (see, e.g., Pacific Western Bank).
Since the invention of modern central banks (the Federal Reserve) in 1914, financial crises have become “wave-like” creatures. One possible reason is that central bank liquidity support makes it easier than before to avoid failure even by those banks most susceptible to loss of trust. This means that as before, they grow under the surface of the normally functioning economy only to suddenly emerge as recurring bank runs. These runs will be quelled by the authorities through central bank emergency liquidity support, mergers and deposit guarantees, but as long as the fragilities in the system are not properly addressed, the crisis will keep re-surfacing, usually with renewed fervor, until the system reaches a breaking point. At this point, two options remain:
The authorities take truly drastic actions, including extended bank holidays (with even Global Financial Lockdown) with forced mergers and recapitalizations to weed out the weakest institutions in the financial system, simultaneously distributing the substantial wealth losses existing, or
The system collapses with bank closing their doors and reducing public access to credit and deposits. An economy-devastating credit depression forms with indebted households and corporations forced to bankruptcies and asset-managers and fixed-income investors to forced liquidations. Highly indebted governments fall into defaults as yields of their bonds skyrocket and pension funds collapse due to severe fall in the assets they hold vs. the income stream they are expected to provide. An outright economic calamity sets in.
So, in the worst-case, in the coming months and years we have to be prepared for:
Collapse of asset markets.
Collapse in global availability of credit and banking services.
Collapse in global demand.
Collapse of global freight.
Collapse of pension funds and governments.
In the worst-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.
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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.
See, for example, Q-Review 3/2019 or Q-Review 4/2019.
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.
First Republic Bank was reported to have lost around 52% of its deposits since the banking rout started in mid-March.
Icelandic banks had grown to monstrous size with their assets passing 900% of the GDP of Iceland.
See, e.g., Investopedia.