European and US Banking contagion – a series of unfortunate events?

Ahmed Butt

Ahmed Butt

Associate

Following the recent collapses of Silicon Valley Bank (‘SVB’) and Signature Bank, the proposed distressed merger between UBS and Credit Suisse, and the First Republic collapse, concerns have grown within the banking sector and investors that a cross-border financial contagion leading to a global financial crisis akin to that of the 2008 financial crisis is imminent.

This article examines the concept of a financial contagion and whether these recent banking crises are likely to be a pre-cursor to a global financial crisis, or whether they should be viewed as isolated incidents in the context of the current global economy and poor risk and portfolio management.


What is a banking financial contagion?

 

A financial contagion is the cross-market or cross-jurisdictional spread of an economic crisis from one affected market, asset class, sector or economy to another. In international banking a financial contagion occurs when a bank responds to a deterioration in that bank’s balance sheet by reducing cross-border loans to countries that are not directly exposed to the initial financial shock.[1]

Holistically, the recent collapses of US banks and the deterioration in their balance sheet has been caused by macroeconomic factors such as the increase of global inflation and increased interest rates, thereby reducing the value of interest rate sensitive bonds held by those banks. This resulted in a loss of confidence amongst depositors and investors, leading to bank runs and the subsequent collapse of those banks as they were unable to meet the needs of their depositors.

The spill over from one economic or financial institution’s collapse leading to another collapse which stems from common crises linkages across asset classes (also known as systemic risks)[2] is seen as a possible financial contagion.  


Why do financial contagions occur?

 

Globalisation and enhanced interconnectivity between financial markets and global economies have resulted in financial contagions becoming more common in the last century. The most recent examples being the Covid-19 pandemic, 2007-2008 financial crisis and the 1997 Asian financial markets crisis.

The increase of global financial integration and interdependence between global economies can be a double-edged sword whereby it can lead to enhancing economic efficiency and growth, but it may also increase a country or financial institution’s vulnerability to a financial contagion[3]. The increased vulnerability stems from greater exposure a financial institution may have to extreme deviations or losses in a specific market or economy that financial institution is exposed to, either directly if the instability is within that financial institution’s home country economy or indirectly if the economic instability stems from the country or market in which its third-party debtors are situated.


Appendix 1: The current bank collapses and their causes

Timeline



SVB Collapse

Root Cause – The root cause for SVB’s failure was SVB’s parent company’s (SVB Financial Group) heavy investment in interest rate sensitive US Treasury Bonds when the Federal Reserve interest rates were low, which led to its overexposure to interest rate fluctuations.

Contributory Cause – The contributory cause that added to SVB’s issues was the drought within the venture capital space resulting in various customers (many of whom were start-ups) dipping into their deposits with SVB to meet expenditures, causing a liquidity crisis for SVB. This in turn resulted in SVB having to sell its government bonds to meet depositor demand.

Material Trigger Event – The material trigger event for SVB’s collapse can be attributed to an announcement to sell off its securities at a loss and providing a forecast stating that its net interest income would see a sharp decline for the following year.
 

Credit Suisse Collapse

Root Cause – The root cause for the Credit Suisse collapse stems from its losses, management changes and scandals over the previous years. These include:
  • The 2019 spying scandal and the subsequent resignation of Credit Suisse’s then-CEO, Tidjane Thiam.
  • The 2021 collapses of Archegos Capital and British finance firm Greensill Capital leading to a pre-tax loss of around $1 billion for Credit Suisse resulting in the departures of Credit Suisse’s investment bank CEO and chief risk and compliance officer.
  • The pulling of $119 billion from Credit Suisse’s customers in the final quarter of 2022 following rumours that the bank was facing impending failure.
Contributory Cause – The contributory causes for Credit Suisse having to be merged with UBS can be attributed to the following factors:
  • General fears amongst investors within the banking sector post the collapse of SVB and Signature Bank.
  • The shares in Credit Suisse plunging to ¾ of its original value from 2022 to 2023.
  • An internal audit finding ‘material weaknesses’ in its balance sheet.
  • The announcement by Saudi National Bank (which is a 10% shareholder of Credit Suisse making it the bank’s largest shareholder) that it would no longer make further funds available to Credit Suisse due to regulatory barriers.
Material Trigger Event – The material trigger event leading to the merger between Credit Suisse and UBS was the announcement by Credit Suisse that it will seek to borrow $54 billion from Swiss National Bank to boost liquidity which led to the stocks in the company to rise (following sharp dips stemming from investor confidence following the SVB collapse). Eventually the Swiss government decided to broker a deal between Credit Suisse and UBS (which is due to complete later this year) for UBS to purchase Credit Suisse and its assets under management for £3.25 billion.
 

First Republic Collapse

Root Cause – The root cause for the collapse of First Republic Bank was that the majority of its deposits (being 67.4% as of December 2022)[4] were uninsured. Fears amongst First Republic’s customers were propagated following the collapse of SVB and Signature Bank where while the US government guaranteed deposits, there were substantial fears that deposits may only be insured for up to the $250k cap via the FDIC leading to a bank run on deposits which inevitably resulted in the bank being unable to meet depositor demands.

Contributory Cause – The contributory causes for First Republic’s collapse and subsequent buyout by JP Morgan Chase can be attributed to the following factors:
  • First Republic’s income was primarily via net interest income from its investments in real estate loans and municipal securities which, at the time of its collapse, were not liquid and not earning competitive interest rates in line with the current high interest rate market. This led to the bank having a high ratio of loans and securities to uninsured deposits[5] with a loan to deposit ratio of 111%[6].
  • First Republic had become downgraded by both Fitch and S&P in the months leading up to its collapse[7],[8] which had a knock-on effect on investor and depositor confidence in the bank’s ability to meet its depositor’s demands and management of its portfolio of assets
  • As First Republic’s assets were predominantly made up in municipal bonds, they were unable to make use of the Bank Term Funding Program.
Material Trigger Event – The material trigger event leading to First Republic’s collapse was the SVB and Signature Bank collapses pursuant to which the bank saw an escalation on deposit outflows and bank runs at unprecedented speed.
 

Collapse causation similarities


The primary similarities in what caused the collapse of these banks can be summarised as the following:
  • Speed of bank runs – due to the interconnected nature of the financial system we currently operate under, cash and assets can be moved in and out of financial institutions at great speed in comparison to bank collapses in the past such as the Northern Rock bank run in which people had to queue on the streets. Digital bank runs are done quickly (even over the telephone) and can be seen to be ‘irrational, destructive and contagious’[9] due to the speed and ease of withdrawals.
  • Strategic options – the pre-cursor to the collapse of SVB and First Republic were the bank’s announcing its plans to weigh up “strategic options” which signalled a red flag amongst its customers and investors who, in contrast to the past, are more than ready to punish bank stocks.
  • Capital ratio and balance sheet – a clear similarity between the failed banks are their liquidity issues stemming from an unhealthy balance sheet whereby their respective loan/securities to deposit/uninsured deposit ratio was greater than one which, in effect, meant that they were not well capitalised (even though they were within the requirements of their respective regulatory regime in respect of capital coverage due to the changes made during the Trump administration) and that their current liabilities far outweighed their non-current assets.
  • Client base – many of the banks that collapsed did not have a diversified client base, for example, Silvergate Bank catered specifically to crypto clients and SVB catered specifically to start-up clients.
  • Exposure to interest sensitive securities – many of the collapsing banks had overexposed themselves to securities which were directly linked to fluctuations to the central bank interest rate which meant that, once the interest rate was raised by central banks due to inflation, the value of these securities fell which meant that these banks needed to sell these securities in order to cover deposit outflows.


Solutions

Alternative solutions for lenders of a synonymous size and nature to the failed banks

Other solutions lenders should consider in order to ensure they do not fall foul of the same mistakes by the failed US regional banks are the following:
  • Ensure that you are operating within the capital adequacy rules mandated by the regulator of your relevant jurisdiction.
  • Ensure that there is an effective strategic risk management strategy in place, whereby if the capital adequacy requirements in your jurisdiction have been relaxed post a governmental change (i.e. the relaxation of regulatory requirements under the Trump regime) or there is a sudden change to the global economy (i.e. interest rates dropping to low levels as what happened during the pandemic)- then not to use this as an opportunity to take on further risk by undertaking riskier loans and investments which could result in being unable to meet the full amount of a bank run by all your depositors.
  • Ensure that the loan to deposit ratio is at a good level (ideally 80-90%).
  • Ensure that you always remain well capitalised and adhere to (if applicable) the tier 1 capital ratio and leverage ratio requirements under the Basel III Accord on bank regulation.
  • Ensure that your client base and portfolio of assets and securities is sufficiently diversified and is sufficient to cover for the risk in the fluctuation of central bank interest rates.


Structural solutions

Other solutions that have been proposed to prepare banks for faster bank runs are both the enhancement of deposit guarantee schemes and requiring banks to hold more highly liquid assets.[10]

One solution proposed by the former Bank of England deputy governor Paul Tucker would involve an overhaul of bank funding by requiring banks to keep collateral with central banks, that would equate in value to 100% of the deposits held by banks on any given day. The collateral would take the form of government bonds, portfolio of loans or other qualifying assets accepted by the central bank which would be subject to a review daily and subject to  additional security being provided to the central bank should the value of the assets fall below an agreed threshold[11]. In return the bank would be provided with cash in the form of a loan from the central bank  if the need to boost liquidity arises.

In legal terms, this would take the form of a loan agreement which would outline the agreed threshold and testing period of the security currently held against the deposits held by the bank under the financial covenant section of the loan agreement. The requirement for additional security would also be a covenant under the loan agreement as well as a undertaking on the part of the bank acting as a borrower.

If these reforms were to be implemented, it would lead to a bank no longer being able to finance its activities using assets tied to their banking businesses as security or collateral[12]. Furthermore, question marks remain on whether implementing these reforms would lead to banks becoming more cautious in their appetite to lend as they will need to ensure they are compliant with the financial covenants stipulated in its agreement with central banks.
 

Financial contagion or isolated events?


An overarching commonality between all the bank failures is investor and depositor fear of negative spill over which has led to fast paced deposit runs and the resultant failure of these banks. Whether or not this fear lingers or subsides, and the domino effect continues to permeate into other markets and jurisdictions will depend on:
  • The exposure/linkages other markets and lenders have in respect of the failing banks or the level of assets a lender holds that are linked directly to macroeconomic factors such as higher interest rates due to inflation.
  • Whether inflation subsides over the following year or increases.
  • What governments/regulators do to reduce the risk of other banks failing and dispel market uncertainty and fear, whether that be a legal or structural change (as proposed in the Solutions section above).
  • Whether lenders are prudent in their approach to risk and portfolio management.
All in all, it can be argued that the current situation is one that could lead to a negative spill over and subsequently a financial contagion to other markets and jurisdictions if there is a propagation of the aforementioned four factors. However, in respect of the recent bank failures their failures can be primarily attributed to poor risk and portfolio management accentuated by the current inflationary economic environment. For the time being the methodology adopted by regulators to mitigate negative spill over is sufficient to subside any negative spill over and prevent a financial contagion.
 

 
[5] Ibid
[11] Ibid
[12] Ibid


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