Banking concerns could temper Fed’s interest rate increases

While all eyes were turned to the UK budget, there has been considerable volatility in stock markets. Troubles at Credit Suisse, Switzerland’s second-largest bank, came hot on the heels of the failure of Silicon Valley Bank and Signature Bank in the US, leading to concerns over the strength of the Western banking sector more generally. With the Global Financial Crisis of 2008 still lingering in investor memories, markets sold off.

Mostly, this panic was primarily focused on the banking sector.  On March 15 Credit Suisse saw its share price down 30% at one point¹, with most other major banks seeing significant losses.  Larry Fink, chief executive of asset manager BlackRock, poured fuel on the fire, saying “more seizures and shutdowns” were likely, and raised concerns over the health of the US regional banking sector.

A cause for the concern has been the large bond portfolios held by banks. Banks are required by regulators to hold a significant proportion of customer deposits in ‘safe’ assets such as government bonds.  Last year saw significant capital losses on government bonds as interest rates rose rapidly. The US treasury market fell by around 16% over the year.³ For the most part, banks can hold bonds to maturity rather than selling in the secondary market and therefore these losses won’t be realised. A problem arises when they need to liquidate parts of their bond portfolio to meet withdrawals of deposits by their clients, crystallising those losses. This was one of the problems for Silicon Valley Bank and Signature Bank.

The problems at Credit Suisse are more complex. Its auditor PwC identified a ‘material weakness’ in internal financial controls at the group. Its largest shareholder, Saudi National Bank, said it would not commit more capital to the troubled bank raising the risk of a collapse of the bank. Ultimately, the bank secured a credit facility of $54 billion from the Swiss National Bank² and its share price – along with that of the other banks – has partially recovered.

Credit Suisse was a greater concern for markets because it is deemed to be ‘systemically important’ – its weakness could threaten the integrity of the wider system. It has been the subject of a series of scandals and poor management, particularly in its investment banking division, which a series of restructuring attempts have failed to address. For the moment, the bailout has calmed markets, but this may prove to be more of a sticking plaster, rather than a solution to solve the deep-rooted problems at Credit Suisse. At this juncture, it is not clear if this additional funding is enough to build-up trust in the bank from its customer base and investors alike. Credit Suisse still needs a more permanent solution to its problems.

There are also concerns about the US regional banking sector. Unlike the larger banks, which have been subject to significant regulation in the wake of the global financial crisis, these banks have less diversified deposit bases. Cash assets for smaller banks are at much lower levels. Depositors have been withdrawing cash and putting it into money market funds, where they receive better interest rates. This has dented liquidity.

The interconnectedness of the banking sector means that the weakness of one bank can create disruption and markets may be febrile for a while as they digest the impact of this fragility. Nevertheless, the majority of major banks – particularly those in the UK and Europe – are extremely well-capitalised and liquid, with diverse depositor bases. They also have smaller investment banking and financial markets divisions.

The final consideration is whether it moves the Federal Reserve (Fed) to change its position on further interest rate rises. Higher interest rates are the catalyst of the current problem in the banking sector. The Fed Chair, Jerome Powell, recently implied that interest rates might rise higher than the market expected, which contributed to the current crisis.³ The Fed will not want to be blamed for another financial crisis and they may turn less aggressive. This possible change in tone from the Fed may help calm things down, leading to lower bond yields, which could improve the value of the banks’ bond holdings. The Fed futures markets are now indicating a 0.25% rise later this month, rather than the 0.5% suggested by Jerome Powell.

In the meantime, it is important to remember that volatility in markets is something investors should expect, and the recovery from the current downturn is unlikely to be smooth. There are signs that confidence is improving in the wake of Switzerland’s central bank loan to Credit Suisse. It is also worth noting that banks are generally far better capitalised and have less bad debts than in the run up to the global financial crisis and measures of financial market risk – such as the spreads on credit default swaps – are nowhere near their level in 2008. However, concerns within the banking sector are always likely to be temporarily destabilising. As always with these periods of volatility, investors need to sit tight and think long-term.

Sources:

¹ Credit Suisse shares soar after central bank offers lifeline, AP News, 16 March 2023

² Credit Suisse shares soar after central bank offers lifeline, AP News, 16 March 2023

³ Refinitiv / Evelyn Partners