A banking crisis is unfolding in the US and Europe. But who is responsible for it? Let us try and understand.
The primary purpose of a financial system is to help finance economic activity and assist us in improving capital efficiency. Financing requires the financial system participants to take and manage risk and deal with uncertainty and earn profit as compensation. An individual firm's ability to manage risk and deal with uncertainty depends on the equity capital and knowledge that its shareholders and managers bring to the firm.
We combine entrepreneurship and regulation to create a stable financial and economic system. An entrepreneur submits himself or herself to regulation in exchange for rules that allow high financial leverage and the central bank's support as the lender of last resort. Since public deposits are the most important source of finance for a bank (60% to 80% of a bank's assets), the banks are not expected to be reckless players.
Public depositors, often lacking an understanding of risk transformation and management processes, place their deposits with banks on trust. Regulators, bank boards, rating agencies, professional economists and finance researchers, academics, politicians, etc. are supposed to assess the impact of banks' choices on the financial system and work together to enhance financial and economic stability. However, we have witnessed multiple governance, regulation, entrepreneurial, and professional failures during the last three-four decades
Bank risk management and Central banks
The most important risks that the banks are expected to manage are credit, interest rate, exchange rate and liquidity risk. A bank's solvency depends on its ability to manage these risks.
The central banks are expected to manage interest and exchange rate volatility for the country, independent of the government. They also help banks manage their liquidity risk by being the lenders of last resort. They are not responsible for ensuring the solvency of an individual bank or any other financial intermediary, as that is the role of the bank board.
However, the central banks, over the years, have given into the demands of various interest groups and have started providing guidance and assurances that protect shareholders. Guidance and assurance have been mistaken for a guarantee by some. Consequently, the 'Greenspan Put' has become a 'Central Bank Put'.
Greenspan or the Central Bank Put: Impact on risk-taking by bank boards
Anna Cieslak and Annette Vissing-Jorgensen in their paper titled The Economics of Fed Put (NBER Working Paper 26,894, 2020) mention the following:
"We show that since the mid-1990s the Fed has engaged in a sequence of policy easings following large stock market declines in the intermeeting period. We refer to this pattern as a "Fed put", by which we mean policy accommodation following poor stock returns."
The 'Fed Put' popularly came to be known as the 'Greenspan Put'.
Any informal assurance from the Central Bank invariably encourages bad behaviour and results in socializing costs and privatizing benefits. The problem manifests itself in the bank-boards taking risky bets that help build money machines, which provide abnormal returns to their shareholders.
Money machines too break down
The Global Financial Crisis (GFC) was caused by credit bets that went sour and the current banking crisis by interest rate bets that have just started unfolding with failures of the Silicon and Signature Bank.
Global Financial Crisis
Credit bets were a series of risk-sharing arrangements that created a world where everyone believed that credit risk was being managed well, even though it was not. Once the defaults started to take place, the central banks tried to solve the solvency problem by providing 'liquidity' to every large financial business, i.e., banks, shadow banks, insurance, etc. They and their respective governments worked out bankruptcies, organised mergers and provided liquidity on tap through various programmes. Investors like Warren Buffet invested billions of dollars in firms like General Electric and Goldman Sachs to help them strengthen their capital, but at a cost that was seen to be fair. At the same time, the Central Banks were providing 'near-zero cost liquidity on tap'. The Central Banks too were helping the private enterprise, but the cost was coming to the households who may or may not have had any role in creating the crisis.
Banking Crisis 2023
The current banking crisis is caused by the fact that everyone seemed to have been living with a belief that the interest rates will remain low for a long time (if not ever). The policy rates in the US and many other advanced economies were indeed low for a long time -- near zero between 2009 to 2016. The Covid period rate cuts and provision of unprecedented liquidity reinforced that belief, and the crisis was born.
During the Covid years (2020 and 2021), we have seen every small or big bank or an investment firm piling up fixed rate government and mortgage debt to profit from valuation gains that follow lower rates. Equity and commodity markets too joined the party. Goldman Sachs renewed its pet commodity super-cycle theory amid one of the worst health crises in decades – a health crisis that caused economic collapse across the world, but we were still expected to believe that we are in the middle of a demand-driven commodity super-cycle.
Global financial crisis demonstrated that the financial system was not really managing credit risk, it was just parking it in places where it was not visible -- insurance companies, pension funds, hedge funds, etc. The current banking crisis suggests that the banks have not been managing interest rate risk and it is sitting on their balance sheets in the broad daylight, without an adequate provision for risk capital.
Jamie Dimon, Chairman of JP Morgan Chase, in his April 2023 letter to shareholders, says the following: "Regarding the current disruption in the US banking system, most of the risks were hiding in plain sight."
Liquidity does not always solve the solvency problem
It is equity that ensures solvency, not liquidity. Liquidity can help us buy time. We must raise equity ahead of time -- not when the risks are already sitting on the balance sheet and are visible to everyone looks at the numbers. The current shareholders would not get a fair deal, if the investors, particularly the big ones, know the firm's vulnerability. Big money too is known for predatory behaviour, as Silicon Valley and many other firms have learnt at an enormous cost.
Returning capital to shareholders and taking risky bets
After the second round of stress tests, the Fed allowed the banks to resume share buybacks from the first quarter of 2021, with cap on dividend continuing.The US treasury secretary Janet Yellen, while speaking to the Senate Committee on Banking on March 24, 2021, stated that the banks have improved their capital positions.Recently, Warren Buffet called the critics of stock repurchases a bunch of "economic illiterates". In short, we have regulators and investors suggesting that there was no real need for strengthening the capital base for the banking or non-banking businesses.
US Banking: Investment and capital structure choices
Let us now draw some insights from the choices that some of the largest US banks have made and the performance they have delivered for their shareholders. Hopefully, we would know whether Buffet's assessment is based on his wisdom or the ideology.
The sample includes a couple of big US banks and the Silicon Valley Bank.I call our big banks as Bank A and Bank B. Bank A is is about 20% bigger than Bank B. I am refraining from naming the big banks in my sample, as we are still dealing with an evolving situation.
Sample Banks' Net Interest Margins have started recovering from their Covid-period Lows
Both the big banks make very similar net interest margin (NIM) and have maintained it close to or above 2%, except during 2021. Silicon Valley Bank has earned higher margins across all these years.
NIM is function of the nature of maturity transformation (ratio between long-term lending and short-term borrowing) and the credit risk that a bank is willing to take. A bank that lends 100% of its money through risk-free variable rate assets and pays variable rate on all its liabilities would have a constant NIM, as it is not doing any maturity transformation or taking credit risk, irrespective of the policy or market rate volatility. No bank does that.
Fed Rate behaviour, rate that impacts Global risk-free rates and credit prices
Chart below shows the movement in Fed Funds yields level. The average rate was below 0.5% for 8 years at a stretch between 2009 and 2016. It once again came down below 0.5% during the Covid-period.
Pandemic hit just when the Fed had begun normalizing the policy rates (after eight years of near zero rates) and they were back where they did not belong in about three years -- there is never an economic reason for nominal or real rates to be zero or negative.
Zero (or near zero) rates with liquidity on tap create perverse incentives in financial as well as real (product and services) markets. We misprice risk, chase yields and cause misallocation of capital, which increases the risk of financial and economic instability.
Central Bank Puts: Are they being taken for granted?
During the last couple of decades, it has got worse as the financial market has come to take 'Central Bank Put at no cost' for granted -- 'Greenspan Put' is now a universal 'Central Bank Put'. Combine the 'Central Bank Put' with growth in shadow banking, lobbying by the self-serving (though in the name of public good), the regulators sleeping on the wheel, rating agencies serving the clients and not markets, the leading economists not being able to recognise that finance does not solve economic problems, and, of course, the politicians cheering them all and we have a near perfect recipe for disaster. We would recall the impact of taper tantrum on Fed's choices during 2013 -- it remained accomodative on liquidity and kept rates close to zero.
The collective chocies of leadership teams at the banks and their supervisors have caused yet another crisis, just when we were recovering from our battle with Covid-19.
Banks' financial leverage choices during the Pandemic years: Were they wise?
Both the banks have grown at a reasonable pace during the last five years, Bank A growing faster than B by nearly 2% per annum for the last five years.
Bank A's growth came with higher leverage (Asset to Equity) which had grown from 10.2 to 12.5, whereas B's leverage too had gone up from 8.9 to 11.2.
Silicon Valley Bank (SVB) grew much faster (nearly4-5x higher than the big ones) and continued to increase its leverage till 2020, though the leverage came down by 0.70 by the end of 2022.
While the big banks are subjected to some amount of regulatory stress testing, Silicon bank had managed to avoid stronger stress tests, as its asset base remained below the threshold limit of USD 250 billion.
Building a debt securities' portfolio
Both the big banks had their loan portfolio grow only by a little over 2%, with Bank A's loan portfolio growth being faster than the Bank B once more. All the while, both these banks continued to invest in debt securities, largely risk-free government, and low-risk mortgage debt.
At the end of 2018, Bank B had nearly 6x bigger investment securities (both Available for Sales and Held-to-Maturity, i.e., AFS and HTM, respectively) portfolio compared to Bank A. But A had small MTM (Marked to Market) gain of 0.1% of portfolio at the end of 2018, with its HTM (Held-to-maturity) portfolio being just 1.2% of its assets. Bank B's portfolio, on the other hand, was 8.6% of its assets, with MTM losses of 1.6% of its portfolio.
At the end of 2022, both the banks had much larger HTM portfolio. Bank A built its HTM portfolio at a faster pace (91.8%) to reach 12.6% of its assets. Bank B grew slowly (32.8%) but now holds 20.7% of its assets as HTM securities. Both these banks built their HTM portfolio during 2020 and 2021, with Bank A adding 300+ billion B adding 400+ billion.
Initially, both the banks were buying these securities for their AFS (Available-For-Sale) as well as their HTM portfolios. As the interest rates started going up, Bank A, which was initially buying them for its AFS portfolio, started shifting them to its HTM portfolio. It shifted about 347 billion dollars to HTM portfolio between 2020 and 2022.
Bank B bought most of its security for the HTM portfolio in the first place itself. It bought about 620 billion dollars’ worth of securities for during 2020 and 2021. Bank A bought about the same amount, but for its AFS portfolio – of which, 347 billion dollars got shifted, as mentioned above.
Silicon Bank was not doing anything different. It came late to the party, though. It built its HTM portfolio during 2021, unlike its big brothers. It shifted about 8.8 billion from its AFS to HTM portfolio during 2022. All hell broke loose for SVB when it tried unwinding its position by selling some of these long-maturity securities (with help from another one of the big brothers) and raising more equity.
Consequently, all the banks are exposed to large potential losses, if they need to sell these securities before they mature and at a time when the market interest rates are higher than the interest payable on these securities.
Financial Performance:Growing Earnings and a reasonable Return on Equity
Both the big banks have experienced an increase in their revenue and profits, though they experienced a large decline in net income during 2022. Bank A does much better on earnings (net income), growing at 3.8% compared to B’s -0.6%.
Bank A earns a reasonable return on equity for its shareholders at 12.0%, in a low-rate environment where the world is struggling to recover from a pandemic that led to economic collapse in most countries. B does not do as well, but still earns 10% per annum. Silicon Bank was doing very well till 2020. It was better than Bank B even during 2022.
Conserving capital or rewarding shareholders: What should have been the priority?
Both the banks have rewarded their shareholder very well through dividend payout and stock repurchases, paying out nearly 70% and 89% of their earnings during the last 5 years. During this period, Bank A and B have piled up $37 billion and $109 billion marked-to-market losses on their respective balance sheet.
The Fed reverses position on inflation, raises the policy rate and tightens liquidity
The Fed announced its first rate increase (0.25% to take to 0.50%) on March 17, 2022, and has continued to raise it to reach 5% on March 2, 2023. The Fed’s balance sheet had grown from about 2 trillion dollars to 4 trillion dollars during the GFC decade. While it tried slowing down a bit during 2012, the taper tantrum forced the Fed to reopen the liquidity tap once more. The Covid panic caused the Fed to add another 5 trillion dollars to its balance sheet, in about 2 years.
As the Fed started raising rates, both the banks started piling up losses on their HTM portfolio -- Bank A has piled up about 37 billion and Bank B over $ 100 billion. Losses for A are about 12.5% of its equity and that for B about 40% of its equity. SVB's losses, at the end of 2022, were about 90% of its equity, up from just 5% at the end of 2021. If the big banks had retained a large share of their bumper earnings during the pandemic, they would not have had any fear from the Fed's interest rate policy. They would also have been able to help the smaller banks like SVB.
It is not that the banks needed to raise fresh capital, they just needed to slow down their stock repurchases and/or lower the dividend payout. During 2021 itself, the two banks made a profit of about $80 billion and paid out nearly $62 billion.
However, unlike out big banks, SVB was not paying out or buying back stock at a break-neck speed. SVB’s payout was less than 5% of its earnings during the last five years. It raised fresh capital of about $5 billion during 2020.
SVB's problems stem from the speed at which it built its investment portfolio and then reclassified it to being HTM (from AFS) without raising adequate capital in advance. It had a chance to raise capital during 2021, a year when the equity market was euphoric, and its own stock was quoting at a Price-Earnings multiple of 21.7 – multiple that even the big banks were not enjoying at that time.
SVB has not survived, and the big banks may need a tax-funded bail out, if the contagion spreads and starts hurting the large banks too, as some people are predicting. Credit Suisse had to be saved through rushed negotiations over the weekend.
Who is responsible for raising risk capital for a portfolio that was built in a near-zero cost and liquidity-on-tap environment?
We all knew that the rates were pushed down to artificially low level (zero and negative real rates) during 2020 and 2021 and had to go up – sooner or later. As mentioned earlier, the provision of liquidity by the Fed too was unprecedented. In such a situation, did these banks need to build a large portfolio of fixed-rate securities without raising adequate amount of risk capital? We know that capital is expensive and interest rate risk management also costs money. But that is why we are taught that there is no free lunch.
Are the banks expected to make their portfolio choices without questioning the Fed's choices or are they supposed to critically evaluate the Fed’s guidance and make their choices?
We also know that the Fed has surprised the market with sharp increases in rates in the past too and that the balance sheet contagion can spread very quickly too is known. In such a situation, liquidity dries up, cost of capital increases and itsavailability shrinks.
Some of the politicians and bankers, ably supported by many influential economists, are suggesting that we must cut rates so that we can avoid another economic crisis. If the Fed does accept this viewpoint and starts lowering rates, the immediate beneficiaries would, of course, be the bankers. It would allow them to feed asset price inflation, withoutany guarantee that we would be able to save jobs and raise the level of employment.
Stock repurchases and dividend payouts
Stock repurchases and dividend are essential tools for returning shareholder funds, but not when the business needs to build its risk capital for dealing with self-inflicted problems amid uncertainty. It is not difficult for us to identify who the economic literates are.
Bank A is in a better position than B, as it paid out a relatively smaller share of its profit. Silicon Valley Bank was doing the right thing by unwinding its HTM portfolio and raising capital, but it got its timing wrong. Its depositors too lost faith in its ability to remain solvent and took the bank down.
A wiser choice, at this stage, therefore, is to raise equity and save jobs and not force the Fed to lower rates. Lower rates would continue inflating asset price bubbles that the policy has been successfully building, post the global financial crisis. One returns capital to shareholders only when there is no need for capital in the business, i.e., either the business has no opportunity for growth or the risks are declining.
Learning for India
In the Indian case, we have a lesson for the Government of India, which owns our PSUs. It must not force banks to pay dividend when the economy is still recovering from the worst health crisis in more than a generation and the banks have not yet recovered a lot of money from fugitive billionaires and multi-millionaires. It must not only retain the current bank profits to build a buffer but also be ready to finance them if the global contagion shows up on the Indian shores -- either in form of lower flow of capital or lower growth in Indian exports.
Professor Anil Sood is a professor and co-founder at the Institute for Advanced Studies in Complex Choices (IASCC). He has been an adjunct faculty at the Indian Institute of Management, Bangalore and Vizag and taught a course on Valuation. He is also an honorary Senior Professor of Finance and Strategy at the Centre for Organisation Development, Hyderabad.