Fear and loathing is spreading through the financial system

At face value, with solid capital ratios and substantial liquidity support from its central banks, Credit Suisse shouldn’t have need to be so brutally dealt with. Its fate, however, underscored the risk faced by Deutsche and any other bank on which the spotlight is turned in this environment.

The banking regulators were fighting the last war, the 2008 financial crisis. That shock to the global financial system was centred on the solvency of banks after the sub-prime mortgage crisis tore destabilising chunks out of banks’ balance sheets and capital bases.

The regulators responded by substantially upgrading the amount and quality of the capital banks, particularly those of global or domestic systemic importance, had to hold and by increasing the intensity of supervision. They also insisted that banks hold sufficient high-quality liquid assets – government securities generally – to withstand a 30-day run.

The US regional bank crisis and the spillover into Europe that enveloped Credit Suisse, however, isn’t primarily an issue of solvency but one of liquidity, or illiquidity, that morphed into a solvency issue when it became apparent that the regional banks, which don’t mark their “held-to-maturity” assets to market, couldn’t respond to massive and near-instant runs on their deposit bases without dumping those assets at substantial losses.

In the digital age, fear-inducing rumours can be spread near-instantly by social media and money can be moved far, far more rapidly than it could in 2008.

That poses a challenge to regulators who thought capital strength and a reasonable amount of liquidity – in institutions which borrow short and lend long and are therefore structurally unable to redeem all their liabilities if there is a run – would be sufficient to shore up their banking systems.

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In the Silicon Valley collapse, it was the rapidity of the flight by holders of non-guaranteed deposits – those above the $US250,000 cap on the guarantee – that triggered its implosion. Some thought will have to be given, by banks and their regulators, to the proportion and nature of those deposits within their balance sheets and how best to respond to a near-instant exodus of them.

In past banking crises it has been the quality of bank lending that caused bank stresses and failures, whether it was the sub-prime lending in the lead up to 2008, or the loans to technology and telecoms in the early 2000s, or the commercial property-related lending in the early 1990s.

The fear this time is that abrupt liquidity stresses within the banks, and the general atmosphere of fear and risk-aversion, could be the catalysts for another torrent of asset-quality-driven losses. They could be the after-effects rather than the cause of a crisis.

The backdrop – central banks continuing to raise interest rates and devaluing fixed interest assets despite the wobbles in their banking systems, the controversial wipeout of “additional tier one” or AT1 bonds in the Credit Suisse bailout that has raised a questionmark over an important source of bank capital, spreads on loans that are blowing out and the truncation of access to equity for smaller banks – will lead to higher costs of funding for the banks and their customers and reduced access to credit for all but the most creditworthy of borrowers.

The potential for a credit crunch is real.

At the most obvious risk is commercial property in the US, where regional banks are (as a cohort) the dominant lenders. Contagion and risk-aversion, however, have a tendency to spread through a system and then, as the Credit Suisse experience demonstrated, spill into other systems elsewhere. As credit conditions tighten further, there is a risk of a wave of unintended consequences for companies and individuals in real economies.

That risk isn’t confined to the regulated banking sector. The major international banks do mark their held-to-maturity assets to market. Most of them (like Australian banks) do hedge their interest rate risks.

There are plenty of smaller banks elsewhere (and some quite larger banks – Silicon Valley was a $US200 billion bank – that don’t. There are some extremely large non-banks, a number that you could argue are of global systemic importance, that don’t face any of the prudential regulation imposed on banks.

It is a jittery environment, with investors searching for the next domino to fall after Credit Suisse, a bank of global systemic importance, was forced into the reluctant embrace of UBS on punishing and humiliating terms.

A lot of lending for commercial property, indeed a significant amount of lending generally, is now being done by private equity. There are hedge funds exposed to the shifting availability and price of credit and to changes in real asset values.

What used to be called “shadow banks” are lightly supervised and less than transparent when compared to banks and, while it is hard to know what lurks in those shadows, we do know that a lot of activity that used to be conducted by banks before 2008 is now undertaken by non-bank entities.

The Fed and the European Central Bank are hosing their systems with liquidity in response to a crisis that their own monetary policies have created by, in the Fed’s case, devaluing assets that were supposedly the safest investments in the globe.

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That is a short-term response to try to calm markets and it may work, as long as the stresses are confined to the smaller banks and Credit Suisse’s plight remains unique. Longer term, however, learnings from the episode will need to be collated and to result in a rethinking and perhaps the expansion of the net of prudential regulation.

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