Global Bank Crisis In 15 Questions… What should investors do?

-It all started on March 8th with the collapse of Silvergate Bank in California, US. On November 11, 2022 as the bank’s deposits fell to $3.8 billion, it declared that it will wind down its operations and liquidate its bank. During the same period, Silicon Valley Bank announced on March 8^th a plan to sell $2.25 billion of shares due to depositors pulling out. The next day the bank’s stock price sank 60%. On March 10^ththe bank fell into US Federal Deposit Insurance Corporation (FDIC) receivership.

–On March 12^th the Signature Bank became the third largest bank failure in US history as it lost 20% of its deposits over a very short time frame and federal regulators put the bank into receivership. First Republic Bank was the fourth potential victim of spooked depositors who were responsible for outflows of $89 billion (roughly more than half of its assets) as of March 20^th.

–US officials are considering expanding the emergency lending facility for banks that would allow First Republic more time to strengthen its balance sheet. As the markets were wondering who else could possibly fail in the US, news from across the Atlantic jolted the investors. Credit Suisse turned out to be the actual fourth victim of the nervous depositor sentiment due to years of reduced profitability, frequent senior management turnover combined with bad management and sizeable losses.

–The latest potential victim of the jittery depositors was Germany’s Deutsche Bank AG whose fate is still up in the air after the bank’s stocks slid 25% since beginning of March on the back of concerns about the bank’s balance sheet. In less than two weeks 4 sizeable banks had failed in a matter of days with the fate of two others still unclear. The big question on everyone’s mind is what went wrong and more importantly was that all a coincidence?

–There are a number of important takeaways for investors here. Markets are really spooked and those with weak fundamentals are very much exposed. The second takeaway is that the US Federal Reserve’s (FED) decision regarding rates will likely have a profound impact on the stability of the banking sector. Therefore the FED is between a rock and a hard place. They have to choose between fighting inflation and avoiding a banking contagion.

–If the FED continues to hike the rates, more banks could fail. That is because banks that hold US bonds are seeing their assets shrink as higher rates mean lower bond prices. The real risk is that if this happens when depositors come knocking on the door, banks could run into a liquidity crisis.

–There is a higher chance of depositors pulling out from banks when rates are higher. Depositors tend to start chasing yields elsewhere, such as money market funds whose returns are much better than that of the banks and are similarly liquid. That is indeed part of what has been motivating depositors recently.

–The biggest beneficiary of the bank failures was the crypto markets as the potential contagion effect in banking system underlined the benefits of decentralized finance. Crypto assets which were already buoyed by the positive equity market sentiment and the dissipating negative sentiment surrounding the FTX blow up, maintained their upward momentum in March. As of March 24^th Bitcoin and Ethereum were up 67% and 46% respectively year to date.

–What should investors expect in the coming days? We may see more bank failures globally as the ripple effect spreads across the markets unless officials declare all bank deposits “insured”, which is an unlikely scenario. We may also see more volatility across different asset classes if the divergence in views amongst market players persist.

–As we have reiterated before, this is a great time for investors to ensure their portfolios are well diversified and include risk mitigation assets and strategies such as gold, trend following, tail risk strategies amongst others. Such exposures would help deliver not only a more stable return stream in the long run but also dry powder to be able to capitalize on market dislocations, particularly when others are swimming naked.

–There is a smaller risk of banking crisis in Turkey versus the global markets given the short selling ban in the Turkish stock market and the limited holding of bank shares by foreign investors. The limited use of derivative instruments and lending offered through complex leverage methods in Turkish financial system and the relatively limited transactions of Turkish banks with global banks also reduce the risk of a banking crisis in Turkey.

–One of the key conditions for the banking crisis not to spread to Turkey is for banks to ensure a more transparent and dedicated financial discipline in order to reduce the anxiety caused by increasing capital reinforcements and non-performing loans. However, balance sheets of Turkish banks that have been shoring up deposits with higher interest rates while lending at lower rates will likely be monitored more closely by investors which may trigger a smaller version of the deposit outflow like the one experienced by the US and European banks.

March turned out to be a scary month not just for investors but for anyone with assets or businesses tied to banks in US or Europe. For this reason in this issue we have dedicated our section to answering questions about the global bank crisis.

1. With which bank and how did the crisis start?

It all started on March 8^th with the collapse of Silvergate Bank in California, US. The bank suffered from loss of confidence by its depositors due to its intimate relationship with the infamous crypto platform FTX and its sister firm Alameda Research both of which had imploded spectacularly on November 11, 2022. As the bank’s deposits fell to $3.8 billion, it declared that it will wind down its operations and liquidate its bank.

2. Which other US banks were also impacted by the crisis ?

Right around the same time, Silicon Valley Bank, the darling of US west coast private equity and venture capital firms was also suffering from depositors pulling out. To cover the outflows, the bank sold part of its US Treasury bond holding at a loss, leaving the bank with a sizeable deficit. To close the gap, on March 8^th the bank announced a plan to sell $2.25 billion of shares. The news sent its shareholders running for the exits and the next day the bank’s stock price sank 60%. On March 10^th the bank fell into US Federal Deposit Insurance Corporation (FDIC) receivership.

Clearly being a bank with a name that started with “S” was a bad omen. Indeed, on March 12^th the Signature Bank became the third largest bank failure in US history as it lost 20% of its deposits over a very short time frame and federal regulators put the bank into receivership.

First Republic Bank was the fourth potential victim of spooked depositors who were responsible for outflows of $89 billion (roughly more than half of its assets) as of March 20^th. Right then 11 US lenders came to the bank’s rescue with a $30 billion cash infusion though it is still not clear whether that will be sufficient to prop up the bank’s balance sheet. US officials are considering expanding the emergency lending facility for banks that would allow First Republic more time to strengthen its balance sheet. However, the bank’s situation looks quite bleak given its equity could already be almost wiped out.

3. Which other banks did the crisis impact outside the US and how were they affected?

As the markets were wondering who else could possibly fail in the US, news from across the Atlantic jolted the investors. Credit Suisse turned out to be the actual fourth victim of the nervous depositor sentiment due to years of reduced profitability, frequent senior management turnover combined with bad management and sizeable losses. The last straw was when Saudi National Bank, the bank’s top backer, said on March 15^th that it couldn’t give any more money given its own regulatory constraints. On March 19^th Swiss officials brokered a deal with UBS Group AG which acquired the 166-year-old Swiss bank for just 3 billion francs ($3.2 billion). 

The latest potential victim of the jittery depositors was Germany’s Deutsche Bank AG whose fate is still up in the air after the bank’s stocks slid 25% since beginning of March on the back of concerns about the bank’s balance sheet.

4. How long did the crisis last?

In less than two weeks 4 sizeable banks had failed in a matter of days with the fate of two others still unclear.

5. Is there any connection amongst the banks that failed or risks failing?

The big question on everyone’s mind is what went wrong and more importantly was that all a coincidence? If you comb through all the research, analysis and commentaries out there, you might think all these banks failed, or almost failed, due to depositors pulling out their money. You could also conclude that in each case the reason that scared the depositors seems to be rather disconnected from the next. For example one was due to crashing crypto prices, another was because of the decision to sell shares due to losses in its US Treasury holdings and another one due to years of scandals and bad management and the list goes on.

Couple bank failures indeed could be random and disconnected events, particularly if they happen under normal market conditions and are small enough so that they don’t pose a threat to the financial markets. However, it is hard not to be alarmed by the recent bank failures, not just because they are all sizeable entities but also because it has all happened in quick succession underlining the direct and strong link within the banking system.

6. What separates this crisis from other bank crises?

Such large bank failures in tandem are rather rare even in the worst of times. In fact last time anything remotely like this happened was during the 2008 global financial crisis when Washington Mutual Bank with over $300 billion in assets ($386 billion in inflation adjusted terms) had failed on September 25^th. This time however not only we have two such large banks instead of one, Silicon Valley Bank with $209 billion in assets and Signature Bank with $118 billion in assets, but they have failed just couple days apart from each other.[1]

7. Why are depositors pulling out of the banks?

There is a higher chance of depositors pulling out from banks when rates are higher. Depositors tend to start chasing yields elsewhere, such as money market funds whose returns are much better than that of the banks and are similarly liquid. That is indeed part of what has been motivating depositors recently. This becomes even a bigger problem and could eventually lead to the bank failing when a bank has a less than stellar balance sheet.

8. What are the key takeaways for investors based on this crisis?

There are a number of important takeaways for investors here. Let’s start with the obvious one: markets are really spooked and those with weak fundamentals are very much exposed. As some of our readers may remember, we had previously shared one of Warren Buffet’s famous sayings “it is only when the tide goes out, you see who is swimming naked” and we have added that the tide was indeed going out. Clearly the tide is out and now we are starting to see who are missing their swim gear… and more importantly who are too far out and therefore most likely to drown.

The second takeaway is that the US Federal Reserve’s (FED) decision regarding rates will likely have a profound impact on the stability of the banking sector. Therefore the FED is between a rock and a hard place. They have to choose between fighting inflation and avoiding a banking contagion. The former requires raising the interest rates but in that case more banks could fail. That is because banks that hold US bonds are seeing their assets shrink as higher rates mean lower bond prices. The real risk is that if this happens when depositors come knocking on the door, banks could run into a liquidity crisis.

9. Would the FED change its interest rate policy due to the bank crisis?

To avoid bank failures, FED may hold off on hiking the rates but that is also problematic as FED may end up with run-away inflation inflicting more damage on the economy.

Therefore, regardless of what assets which banks hold, markets are laser focused on FED’s stance regarding the rate hikes and particularly whether they will continue hiking despite the banking issues. The answer is probably “yes”. Indeed at their March 22^nd meeting, FED hiked the rates another quarter point while reiterating their resolve to continue fighting inflation even though they acknowledged the looming banking crisis. In other words, their priority is inflation, not recession.

10. How did the banking crisis and FED’s decision to hike rates affect the equity markets?

This news just added fuel to fire across all markets which were already swinging back and forth before the FED meeting. Case in point, the US equity market index SP500 dropped 3.5% between March 8^th, the day of the first bank failure in the US, and March 14^th when the US inflation data came out better than expected. Indeed, the headline consumer price index (CPI) showed the annual inflation had dropped to 6% from the previous month’s reading of 6.4%. This news boosted the index by 3% over the following 10 days. After all was said and done, as of March 24^th SP500 was flat on the month and simply held onto its 3.4% gain on the year. Similarly, the global equity indicator MSCI All Country World Index (ACWI) and the emerging market index MSCI EEM were roughly flat on the month and 3.8% and 2% up on the year respectively.

FED’s rate decision and the looming bank crisis didn’t have a visible impact on some equity markets. Despite a phenomenal 2022, Turkish stocks were down year to date with -8.7% return in local terms (-10.4% in US dollar basis) as of March 24^th. A big driver of the drop was the massive earthquake on February 6^th that is estimated to have caused major damage. In the meanwhile the Turkish Lira continued its downward trajectory with -1.9% loss against the greenback over the same period. Turkish market volatility might remain elevated until the Presidential election which will take place by mid-May.

11. What could cause a bank to fail?

While it may sound like the main culprit in bank failures is the higher interest rates, that is really not the case. It is all about the depositors and their level of confidence, or lack thereof, in their bank. At the end of the day, there is not a single bank that can withstand a so-called “bank run”, even those with the strongest balance sheets. This is due to the fact that banks are set up in such a way that only a fraction of the depositors’ money are kept as “reserves” for liquidity purposes. The rest is put to use and given out as line of credit, mortgages or other loans as this is how the banks essentially make money, borrow low and lend high.

Those banks without a lending facility or that prefer to have more “liquid” reserves may keep a good amount of these deposits in interest bearing “safe” assets such as bonds. This setup works quite well except when rates go up over a short time frame, as they have done recently, and bonds plummet in value creating a hole in the balance sheet. This still doesn’t cause an issue unless depositors decide to ask for their deposits back and they do that in a short time span creating a “bank run” which prompts the banks to sell such assets at a loss.

herefore, you may think banks that don’t have a big bond portfolio and tend to give out different types of loans should be in the clear. That is however not the case. Such loans, credit lines and mortgages tend to be longer duration assets and are hard to liquidate on short notice. Therefore, any kind of bank run is likely fatal for a bank given they are not set up to provide big chunks of liquidity on short notice. This makes them very susceptible to any negative news or even rumours about their balance sheet or financial stability.

12. Which markets benefitted from the bank failures?

The biggest beneficiary of the bank failures was the crypto markets as the potential contagion effect in banking system underlined the benefits of decentralized finance. Crypto assets which were already buoyed by the positive equity market sentiment and the dissipating negative sentiment surrounding the FTX blow up, maintained their upward momentum in March. As of March 24^th Bitcoin and Ethereum were up 67% and 46% respectively year to date.

Softer than expected winter in Europe and North America continued to weigh on the crude oil prices. As of March 24^th the first month futures contract for US crude oil WTI was down by -13.7% year to date. After a directionless 2022, gold continued its hike surpassing $2000 mark once again due to flight to safety triggered by fears of bank contagion. As of March 24^th the first month futures contract for Gold was up by 9% on the month bringing its year to date return to 9.6%.

After a dire 2022 and a bumpy start to the year, bonds had a decent come back in March. Similar to crypto assets and commodities, bonds benefitted from flight to safety as well. The markets also priced in the negative impact of bank failures on the economies of developed countries. This meant the yields across the US yield curve dropped which means the bonds prices went up.

This was reflected in the Bloomberg Global Aggregate Bond Index which as of March 24^th was up by 2.7% on the month and 3.7% on the year. Bloomberg Global Corporate Bond Index was also up on the month, but with 2.2% which undershot the aggregate index. This Is because the aggregate bond index tends to benefit from risk-off periods more than corporate bonds which are deemed riskier. The Bloomberg Global High Yield Bond Index, which is considered riskier than corporate bonds, was down by -1% month to date and up by 1.4% on the year over the same period.

13. Will the banking crisis continue? What should the investors expect in the coming days?

We may see more bank failures globally as the ripple effect spreads across the markets unless officials declare all bank deposits “insured”, which is an unlikely scenario.

What should investors expect in the coming days?

We may see more volatility across different asset classes if the divergence in views amongst market players persist. For instance, as of March 24^th the difference between the highest and lowest year-end targets by strategists for SP500 is at 47%, the widest at this time of year in two decades, as per the data compiled by Bloomberg illustrates below.

14. What should the investors do now to protect their portfolios?

As we have reiterated before, this is a great time for investors to ensure their portfolios are well diversified and include risk mitigation assets and strategies such as gold, trend following, tail risk strategies amongst others. Such exposures would help deliver not only a more stable return stream in the long run but also dry powder to be able to capitalize on market dislocations, particularly when others are swimming naked. After all, when investing is not just about what to buy but also when to buy, and for that the key is always good analysis and sufficient liquidity. Therefore the Turkish markets should follow the most recent developments closely and learn from this banking contagion.

15. Would the global banking crisis spread to Turkey? Would Turkish banks get impacted by it?

In order to gauge the possibility of a global banking crisis impacting Turkey, we must first look at the relationship amongst the banks that have failed or are at risk of failing. Other than the jittery depositors story, another common denominator amongst such banks is that they are mostly traded publicly and across various global markets. Therefore, even the slightest concern about a bank creates a visible downward pressure on the bank’s stock prices almost instantaneously. This weakens an already weakened balance sheet, which therefore could partially or completely wipe out the bank’s equity value. Turkish banks could likely experience a similar pressure on their stocks due to their balance sheets. That being said, this is a smaller risk in Turkey versus the global markets given the short selling ban in the Turkish stock market and the limited holding of bank shares by foreign investors.

Another reason for the recent bank failures is the rising interest rate environment and the deposit rates of banks remaining below other liquid alternatives as discussed earlier. However, the ability of Turkish banks to offer competitive deposit rates is another important factor that alleviates the risk of such money outflows and thus the risk of bank failures.

The limited use of derivative instruments and lending offered through complex leverage methods in Turkish financial system and the relatively limited transactions of Turkish banks with global banks also reduce the risk of a banking crisis in Turkey.

However, as we noted before, even banks with the strongest balance sheets cannot survive in case of a bank run. Therefore, any crisis of confidence by investors or depositors could spread the banking crisis to Turkey.

Also, balance sheets of Turkish banks that have been shoring up deposits with higher interest rates while lending at lower rates will likely be monitored more closely by investors which may trigger a smaller version of the deposit outflow like the one experienced by the US and European banks.

Investors should also pay attention to the fact that Turkish banking system is increasingly influenced by political economic policies and therefore appears to be driven more by public officials in the recent years. One of the key  conditions for the banking crisis not to spread to Turkey is for banks to ensure a more transparent and dedicated financial discipline in order to reduce the anxiety caused by increasing capital reinforcements and non-performing loans. Therefore, an increase or decrease in guidance from public officials could be a determining factor of the future of Turkish banks.

For all the above reasons, it is in the best interest of investors to diversify their deposits using a broader number of banks as well as a wider array of alternative investment instruments in their portfolios such as gold.

ELA KARAHASANOGLU, MBA, CFA, CAIA

International Finance Expert

karahasanoglu@turcomoney.com

ela.karahasanoglu@ekrportfolioadvisory.com

https://www.linkedin.com/in/elakarahasanoglu/

[1] https://en.wikipedia.org/wiki/List_of_bank_failures_in_the_United_States_(2008–present)

Who is Ela Karahasanoglu?
Ela Karahasanoglu is the CEO of EKR Total Portfolio Advisory based in Toronto, Canada. EKR advises global institutional investors and asset managers on alternative investment and portfolio construction from a total portfolio perspective.

Previously, Ela was the Head of Total Fund Management team at BCI, one of the largest asset managers in US and Canada with assets over $200 billion. Ela has over 25 years of international investments and executive leadership experience. She has worked with global asset management, consulting and pension fund companies in London, New York and Toronto including UBS, Merrill Lynch, Mercer, CIBC Asset Management and BCI. Ela is a frequent speaker and a globally published investment thought leader in institutional asset management. Amongst the awards she has received includes the “Global Leading Innovator” in 2020 and “Hedge Fund Rising Star” in 2018 by The Institutional Investor, one of the leading publications in the institutional investment field. Ela is a graduate of Uskudar American Academy in Turkey and has earned her MBA from Georgetown University in 2000.

She has been a CFA Charterholder since 2002 and a CAIA Charterholder since 2010. Ela serves as the Co-Head for CAIA’s Toronto Chapter since 2018. She is married and lives in Toronto.