In Banks, We Don’t Trust?

According to known history, banks as an idea began around 1,800 BC in Babylon. It started replacing moneylenders who would make loans to people. Over time banks, as independent entities became the beacon of trust in society, and started making loans as well as accepted deposits. They also changed money.

Modern banking as we know it today has roots in the early 17th century. And throughout their existence banks have gone through crises. Probably the first recorded history of bank runs goes back to 1793. In 1814-1816, and 1825 there were ‘runs’ on banks when people lost confidence and withdrew their money. And each time there was a wave of bank failures.

So confidence and trust of people and the larger society are two key components of a bank’s success. Even well-capitalised banks can succumb to a crisis of confidence. And that is exactly what happened to Credit Suisse.

Having said that, it is very hard to know what’s behind a bank’s balance sheet, and credit Suisse is a prime example of that. In this case, you have a bank with over CHF 531 billion in assets and CHF 1.2 trillion of assets under management, but somehow it agreed to sell itself to a rival, UBS for around CHF 3 billion. And the agreed sale also wiped out CFH 17 billion of the AT1 bondholders ( additional tier 1 bonds that come with perpetual maturity, which converts into equity at the time of crisis ), giving union bank of Switzerland a very strong cushion against any future losses.

On paper, this looks like the deal of the century for UBS, and the bank will likely profit from this acquisition. But all this also makes a big mockery of the financial markets. I won’t be surprised if there will be litigations going forward, and also down the road, the regulators in Switzerland will have to consider breaking a large bank which holds more than 50% of the deposit base.

A bank like Credit Suisse was once a powerhouse but it has been blessed with some horrible bosses, low on real talent and high on everything else. Perhaps, the shareholders should have recourse against the managers who destroyed so much shareholders’ value during their tenure. Also, regulators like FINMA did fail in their duty to demand the management of the bank to do better.

Globally, the banks have been too focused on compliance when it comes to opening a bank account and how a customer operates that account, which is the right thing to do, but at the same time, banks have not been equally focused on their balance sheet risk, especially the funding mismatch. For example, what’s the point of owning publicly trade-able securities when it is not going to be sufficient to cover flight of capital? Regulators always end up coming short when it comes to supervision, and central banks fail to fully grasp what impact their policy decisions might have across the sector.

No doubt raising rates aggressively was going to come with collateral damage, and we are seeing the aftermath of that. But that’s not to say, that the entire banking system isn’t sound. As I see it, banks in the UK and Europe as well as the US ( not every bank ) are a strong buy. Also, going forward, I think the central banks should freeze raising rates and let the economy adjust. Recessionary pressure will tame inflation. And speaking of inflation, we do need better metrics to measure real inflation as the current metrics are broken and simply put, out of date. I don’t see banks rushing into a lending spree. All this is going to slow down the economy. So the merit and basis of raising rates are not that compelling anymore.

Immediate lessons from the failure of Silicon Valley Bank along with Signature Bank and the flight of billions of dollars worth of deposits from Credit Suisse should push regulators to find ways to insure bank deposits because currently not all deposit is equal. Central banks will have to create a resource that banks could tap into if there was a run on the bank. Also, I feel that society also needs to be educated. With digital currency on the horizon, does it not make sense for central banks to hold all the money in the system in its central digital ledger, protecting the depositor aka the owners of the money, and let the banks simply serve as a utility medium?

As I see it, models like mark-to-market are broken because markets keep finding ways to misprice the assets. Perhaps, central banks working closely with the banks should create a permanent vehicle to insure the assets held in the banks’ balance sheet till maturity for at least 60% of its value. Banks could pay an insurance premium for insuring against any rapid loss of value of assets held in their balance sheet. Investors have already realised that securities like AT1 bond rank below equity holders. So I do wonder if this capital form is now a failed experiment.

By managing the takeover of Credit Suisse by UBS, the Swiss government has bailed out the financial system in the country and also reduced the risk of serious contagion globally. But for obvious reasons, it isn’t willing to acknowledge the bailout because apparently, the repeat of the 07/08 financial crisis wasn’t on the cards, and the working thesis is that taxpayers won’t be asked to bail out the markets. I can understand the messaging, but that is how you create mistrust and loss of confidence.

In the end, it is the trust and confidence of people that make an economy and the financial markets work. I do think some lessons were learnt from the financial crisis, but policymakers and politicians should restrain themselves from making false promises. The fact remains, it’s hard to protect such a complex financial system without risking taxpayers’ money. And that is an important acknowledgement.

Regulators can always work to lower the risk of future financial crises, but it will always be a work in progress. But if we stop trusting in our banks then, there will be no economy left as we have come to know it. Not all banks are created equal, and some will fail because of several factors including their business model. To a large extent, it is the business model of credit Suisse and Silicon Valley bank that failed both banks.