Industry Voice: Multi-asset allocation views — perfect storm or storm in a teacup?

Briefly, banks have assets, such as securities they hold and loans on which clients pay interest, and liabilities which, interestingly, include deposits people make into the bank. When clients make a deposit, they become creditors of the bank. And they are creditors governments are concerned about because if there's a risk of them losing money, a) they are not all rich and sophisticated individuals, and b) there is the potential for economy-wide confidence to be damaged. Nothing makes people want to queue up outside a bank for their money more than seeing people queuing up outside a bank.

This is why governments in all major economies have introduced deposit insurance: up to £85,000 in the UK, €100,000 in the euro area and $250,000 in the US. The intention is to protect savers' money, but also to help banks to rely on this money as a source of funding. If depositors have confidence in the safety of their savings, then it is a stickier funding source than, for example, the short-term wholesale funding banks used in the run-up to the global financial crisis (GFC).

The problem with SVB and Credit Suisse was that a relatively small portion of their deposit funding was as sticky as it might be for a regular bank. Firstly, both relied mostly on companies and wealthy individuals for deposits. This meant the value of the government guarantee was too low to protect most clients' deposits. Only three per cent of SVB's deposits were small enough to be covered by the $250,000 guarantee. Therefore, the guarantee wouldn't stop savers from moving their money out.

Secondly, the two banks were not necessarily attractive places to save. We have seen a sharp rise in yields on money markets, while some challenger banks are offering better deposit rates. Established banks haven't kept pace with the yields available on those competing assets. Credit Suisse had suffered deposit outflows for many years - over CHF100 billion in the fourth quarter of 2022 alone - so it could hardly be considered sticky money.^[II]

These issues were compounded by the fact bank runs can now happen virtually. Concerns can arise on social media and withdrawals made online in a couple of clicks. Although this could happen to other banks, SVB and Credit Suisse were outliers compared to their peers in that they were significantly more reliant on flighty deposit money.

For example, although we also saw social media noise and investor concerns around Deutsche Bank in March, a much smaller proportion of that bank's funding comes from uninsured deposits (c. 70 per cent of its retail deposits are insured)^.[III]

Credit Suisse and SVB were also specific cases in terms of assets

Assets were another source of Credit Suisse and SVB's difficulties. Banks' balance sheets tend to have a large pool of liabilities (funds they've borrowed from savers or markets) and a large pool of assets. The equity is the small sliver of difference between these two pools.

SVB had invested most of its assets in fixed-income securities, whose value had fallen steeply as interest rates rose, creating large unrealised losses. When it was forced to sell assets to meet redemptions from depositors, those losses became realised and crystallised the bank's insolvency.

The issue with Credit Suisse was one of confidence, which dictated market valuation of the assets. Credit Suisse has suffered serious risk failures in recent years, such as with Greensill and Archegos.^[IV] That impaired confidence in the value of the bank's assets, thereby reducing the value of that thin sliver of equity - and causing the share price to plummet to $0.88 (from a post-COVID high of $14.49 on February 26, 2021).^[V]

In principle, if there was a big markdown in assets, that kind of concern could arise even in a bank with a stable deposit base. The question would then be whether that bank has enough capital (chiefly equity) to protect the firm's solvency against the markdown.

But if one thing was a focus of regulators post-GFC, it was ensuring banks have stronger capital bases, particularly in Europe. They are in a much better position today to withstand volatility in their assets or realising losses than in 2007.

For Deutsche Bank, the source of investors' concern was that it was one of the European banks most exposed to commercial real estate, an asset class that looked challenged in March. But, as a proportion of Deutsche Bank's overall asset base, commercial real estate isn't particularly large, so its capital buffers should be comfortably sufficient for this specific risk.^[VI]

Given SVB and Credit Suisse were such outliers in terms of their sources of funding and banks' capital levels are much more secure than before the GFC, the scope for a near-term Lehman-type domino effect appears limited.

What will be the medium-term impact on the credit cycle?

In terms of medium-term consequences, higher interest rates may increase banks' funding costs, which could impact their appetite to lend, but the impact of the SVB and Credit Suisse failures seems limited otherwise.

Most banks have benefited from higher interest rates, for example by increasing mortgage rates, while not necessarily offering higher deposit rates. This cannot go on indefinitely, but banks may not want to attract a lot of deposits remunerated at a higher rate, in which case they will not be able to expand lending by much either.

In the markets, the way Credit Suisse was resolved involved big losses for creditors who had invested in "Additional Tier 1" capital securities, which were not expected to lose out ahead of equity (see Figure 2). That has generated uncertainty and volatility for this source of capital for banks.^[VII]

Figure 2: Order of priority for bank creditors

Source: BondAdviser, Aviva Investors, as of April 19, 2023.

The main concern is whether higher funding costs and potentially lower risk appetite affects the supply of credit from banks to the broader economy. It is too early to gauge the precise risks to growth because we don't know how banks will respond, or whether sectors like commercial real estate will find other sources of funding. But it clearly is an important point to watch.

What does it mean for policy?

Strong jobs and inflation numbers in February pushed up market expectations for the path of interest rates, particularly in the US. But the uncertainty around bank lending means the private sector may now be tightening monetary conditions so central banks don't have to raise interest rates as much as expected.

The difficulty is no one, not even central bankers, know how much more policy tightening may or may not be necessary. What will credit conditions be in three- or four-months' time? How high will inflation be? Both are open questions right now.

If credit conditions are not severely affected and inflation proves stubborn, interest rates may need to continue rising. However, central bankers know they will have to move gradually to have time to assess the knock-on effects of tightening, especially if those are in hidden corners of the financial system.

In the US, interest rate futures are implying a cutting cycle but probably reflect the middle of two outcomes; one where the central bank can keep rates fixed or even raise them slowly; and the other where it is forced into rapid cutting because bank lending declines significantly.