Neil Birrell, Premier Miton’s Chief Investment Officer and manager of the Premier Miton Diversified Fund range, reviews the impact of the collapse of banks on both sides of the Atlantic and what the ramifications might be.
For information purposes only. Any views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions
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The immediate flow of information in the world that we inhabit today means that financial markets move to reflect news and events almost immediately and often move too far before retracing some, or all, of the move. A good example of this was around the collapse of Credit Suisse.
Banking is a business built on confidence
The photographs of lines of people queuing up to remove cash from their bank accounts are very evocative and as recent as Northern Rock in 2008. More typically today it’s processed through a laptop or a phone, but that has the same effect, just faster. When companies are withdrawing money, the sums can be very large. This is caused by fear of losing all your money. Why? Because the confidence that your bank will be solvent tomorrow has disappeared.
That confidence is built on a bank displaying strong controls and management. In the case of Silicon Valley Bank (SVB) and Credit Suisse (CS), both of those characteristics were missing. That had been known with regard to CS for some time, and was, arguably, already reflected in the prices of its bonds and equities (company shares) and whilst not in a great condition, it was far from terminal.
However, with both these banks, and others in the US in particular, their financial positions and liquidity profiles (how quickly and easily cash and assets can be sold and moved) were put under so much stress they broke.
Into the breach
In the US the central bank, the Federal Reserve, stepped in to shore up the banks, as did large, better capitalised commercial banks; it is in no one’s interests for banks to fail. There are others, such as hedge funds, who will be very interested in buying the failing bank’s book of loans to clients at distressed prices, just as the UK loans of SVB were purchased by HSBC. This is a free market economy operating efficiently, although shareholders lost all their money, which is the ultimate risk of being a shareholder.
The situation with CS was, and is, somewhat different. Even though it has got smaller over the years, particularly on a relative basis, the bank is a key player in the financial services industry in Switzerland, which is, in itself, a cornerstone of the economy and part of the country’s fabric. A failure of CS, with depositors losing their money, was inconceivable. The Swiss National Bank provided a very short term solution by providing a liquidity facility, but had to find a long term solution very quickly. That came in the form of a take over by its larger and stronger Swiss cousin, UBS.
But that brought enormous complications and a fraught period for bond and equity holders, with the proposed deal structure changing over the weekend and trading taking place in various CS and UBS securities (financial instruments, including company shares and bonds).
In short; chaos. Uncertainty is the bane of an investor’s life and that is exactly what we got. It is difficult to talk too much about the short term movements in markets or individual investments in such volatile markets, but it can provide opportunity as well as threat.
The Swiss authorities made some interesting decisions. Obviously the ramifications for the nation were high on the agenda and whilst they played within the rules, their decisions relating to how they treated the different parts of the capital structure of CS (bonds and equity) surprised just about everyone. This related particularly to the Additional Tier 1 (AT1) bonds (bonds issued by a bank that can be converted into equity) being treated worse than the equity. This cannot take place under EU or UK regulations, which reduces the wider uncertainty.
Once the situation was more understood, prices rallied and some sense of relief held sway. The next few days will provide more clarity to the future of the UBS/CS deal.
The bigger picture
Any stress in the financial system is bad news, but it does seem that, as it stands, the specifics we have been through in the last two weeks might be containable.
However, there are wider reaching implications. Firstly, it will mean that the lending conditions for borrowers – corporate and consumer – will be tighter going forwards. That is particularly concerning for companies that need to fund their business or growth plans. Secondly, tighter lending conditions will result in less economic activity and increase the risk of recession along with more companies failing and unemployment rising; that will be the case in all geographic regions.
On the biggest stage it gives the central banks a massive conundrum; they are in the midst of a tightening cycle, which means increasing interest rates to beat inflation. Hitherto, the equation was two fold; balancing how far and how high interest rates needed to go to beat inflation without doing too much damage to growth. They had decided on the need to beat inflation as the key driver. Now they need to add into that the risk of causing great stress in the financial system by putting up rates too far. To mix my analogies; that will trump everything.
Central banks, governments and regulators will be totally focused on supporting the global financial system. The risks of a steeper economic slowdown and recession are enhanced; but that is more palatable than a financial crisis. Notwithstanding that, it is what everyone is talking about, so will be, to one degree or another, reflected in markets.