Are we in a banking crisis?

Sascha: [00:00:03] I'm Sascha Kelly and welcome to the dive where we break down one story in the world of business because who said business news needs to be all business? 

Audio Clip: [00:00:12] Markets fall in Europe and the U.S. fears grow over the stability of the banking industry that. 

Audio Clip: [00:00:17] Swiss shares shed around a quarter of their value. 

Sascha: [00:00:20] The global banking system is under some extreme stress over the past few weeks. Three U.S. banks have failed and Swiss bank Credit Suisse has been acquired by its biggest rival after it also ran into trouble. 

Audio Clip: [00:00:35] When Silicon Valley Bank collapsed. Last week, it set off a domino effect across the banking industry. Signature Bank failed to First Republic had to be bailed out by other banks overseas. Credit Suisse needed a big loan from the Swiss version of the Fed to stay afloat. 

Sascha: [00:00:50] And if you're tuned into financial media, you'd be worried. Is this the start of a run on the banks, a financial crisis, or is this a lot of media hype that will just end up being the latest financial panic that graced headlines for a couple of weeks? And then we all moved on. And perhaps most importantly, when it comes to banks on the other side of the world, how concerned should we be here in Australia? It's Wednesday, the 22nd of March. And today I want to know why are we bailing out these banks and where does it stop? To talk about this today, I'm joined by my colleague here at Equity Mates. It's Darcy Cordell. Darcy, welcome to the dive. 

Darcy: [00:01:29] Hi, Sascha. Thanks for having me. 

Sascha: [00:01:31] Look, this story developed really quickly. Can you give me a one minute rundown on what's happened so far? 

Darcy: [00:01:37] Yeah. On the 8th of March, Silvergate Bank voluntarily shut down after its financial position became untenable. Then, two days later, on the 10th of March, Silicon Valley Bank, the 16th largest bank in the US, collapsed after a flurry of customers tried to pull their money from the bank. On March 12, Signature Bank collapsed after a run on its deposits by customers who were spooked by the implosion of Silicon Valley Bank. Then on March 15, shares in Credit Suisse fell more than 30% in a single day, which led to Swiss authorities announcing that provide financial support to the bank. The next day, March 16, First Republic Bank in the US was on the verge of collapse as customers also withdrew their deposits. The following day, US Treasury Secretary Janet Yellen and Jamie Dimon, the CEO of JPMorgan Chase, organised a private sector rescue where American lenders deposited tens of billions of dollars of cash into First Republic to try and shored up. And then on March 19th, UBS acquired Credit Suisse. 

Sascha: [00:02:41] So, Darcy, the big question, why has this all happened? It's just date after date and bank after bank, what have these banks done to get into this position? 

Darcy: [00:02:51] This is mostly to do with interest rates. 

Audio Clip: [00:02:54] Now, regulators are on top of things. Our banks are well-capitalized with strong liquidity positions, but it's still a reminder of the risks, the uncertainties and the vulnerabilities in the global economy as interest rates rise around the world. 

Darcy: [00:03:08] In the past 15 months alone in the US, we've gone from a time where interest rates were just above zero to almost 5%. This is the most aggressive hike in rates since World War Two, and most banks were just not expecting rates to jump this much and this quickly. When interest rates go up, the prices of bonds go down. And this is because bonds are all about yield. 

Sascha: [00:03:30] Which is the interest that you earn every year for holding a bond. 

Darcy: [00:03:35] Yep, that's right. 

Sascha: [00:03:36] I find putting numbers to these situations always helps things make more sense to me. So can we run an example here? Sure. [00:03:44][7.8]

Darcy: [00:03:44] Let's say I buy a $100 bond that pays 1% interest, so that would be $1. All of a sudden, the Federal Reserve raises interest rates to 4%. So now investors can get 4% interest on a bond somewhere else. So if they're going to buy mine, they want 4% interest. But my $100 bond paying $1 a year, it's just not going to cut it for them. So if I want to sell it, I'm only going to be able to sell it for about $25 because my $1 a year interest is 4% of $25. [00:04:20][35.7]

Sascha: [00:04:21] Basically, we'd need four of your bonds to make up what's the new interest rate of 4%? 

Darcy: [00:04:28] Yeah, and that means the value of these bonds plummets. 

Sascha: [00:04:31] Okay. 

Darcy: [00:04:32] As a rule of thumb, every bonds price moves down by 1% per year of duration. If interest rates move up 1% and vice versa. 

Sascha: [00:04:42] And that matters because bonds you buy for a fixed term. So you're committing your money for a certain number of years and banks buy a lot of bonds. And so as interest rates have risen, all these banks are losing a huge amount of money. 

Darcy: [00:04:58] Yeah, that's right. When you put your money in the bank, Sascha, it doesn't just sit there. The banks go. And invest it. They put it into bonds. The problem is these bonds haven't been performing because of the rise in interest rates. The US banking system has $620 billion in unrealised losses on investment securities, according to the Federal Deposit Insurance Corporation. 

Sascha: [00:05:19] You know, every time we say these numbers, it makes any of the dogs that I've bought in investing just puts them into perspective. I will say 500 bucks, thousand bucks on a bad investment. I've never lost $620 billion, Darcy. 

Darcy: [00:05:32] It's a crazy figure, but actually, surprisingly, that figure in itself isn't a problem. Let's return to my $100 bond that I can now only sell for $25 if I just wait it out at the end of the term, I get my full $100 back from the company or government that I lent the money to in the first place. I don't actually have to sell it for $25. I can just wait it out until the end of the term.

Sascha: [00:05:56] Because just to remind you, these bonds are purchased for a fixed number of years. 

Darcy: [00:06:00] But that doesn't apply to Sascha if I'm forced to sell. And here lies the biggest problem for the US banks. Most US banks would hold these bonds until maturity and until they get their original investment back. But lately, people have caught wind of the problems in Silicon Valley Bank and they've started withdrawing their money from banks. So for the banks to ensure they had the money to give to their customers who are trying to get their money out, they are forced to sell their bonds at a loss. And that is when Silicon Valley banks stop giving customers their money back. They didn't have enough money to give it to them. 

Sascha: [00:06:35] Wow. Okay. And that brings us to the bailouts, because the banks that couldn't return money to depositors have been supported either by governments or central banks or other banks or private investors so that depositors don't lose any money. But this has been pretty controversial. Help me get my head around the effect these bailouts have. Tell me about the scenario. The world that runs without intervention, without bailouts. 

Darcy: [00:07:03] The US government, they announced their decision to bail out Silicon Valley Bank on Sunday. If they hadn't. On Monday, depositors would have started lining up outside the bank, trying to get their money out. When the doors opened at 9 a.m., Silicon Valley Bank wouldn't have the cash on hand to give all of these customers their money. The good thing here is that deposits less than $250,000 are insured by the government. So those customers are okay, but customers with more money than that. Think about large companies. They all of a sudden don't have the cash to pay their staff. 

Sascha: [00:07:35] Even medium sized companies. D'Arcy Like $250,000 could be just a small business.

Darcy: [00:07:41] Yeah, absolutely. And at the same time, customers of other small banks, they're saying what's happening and they're getting nervous. They think, What if my bank is next? So then lines start forming at other banks, and these banks have been buying bonds as well with plans to hold them until maturity. But that means they haven't got the money to return to their customers. So it just spreads throughout the banking system. 

Audio Clip: [00:08:04] The market did not respond like they thought, and the ramifications Were that They were running out of money.

Darcy: [00:08:10] So, yes, imagine you're one of those companies with more than $250,000. You aren't able to get your money out and you've got to start conserving the cash that you do have. Eventually, you'd struggle to meet your payroll and you might have to lay off staff. And this is why bank failures are so damaging. The psychology of a bank failure often leads to further bank failures and then general business failures as well. 

Sascha: [00:08:34] Okay, so that's the world without bailouts. Now, tell me about what happened. Tell me about the world with bailouts.

Darcy: [00:08:40] Let's rewind to that Sunday. So the US government announced they would guarantee all customer deposits at Silicon Valley.

Sascha: [00:08:47] Bank regardless of size. 

Darcy: [00:08:49] Correct. And in this world, customers are still lining up on Monday to get their money out of the bank. But the difference is they can they can get their money. The federal government has given everybody their money, which they then pass on to the customers. And in return, the government has taken over eBay's bonds and it will hold them to maturity and recover their money that way. But at the same time, customers of other banks, they're still getting nervous. They don't want what happened to Silicon Valley Bank to happen to them. So they start lining up outside their bank to withdraw money. Now, this is the interesting part. The government is faced with a choice. Do they bail out this next bank and the one after that? And where does it stop? And that's kind of where we're at now that the US government and the Federal Reserve has spent about $140 billion guaranteeing the deposits at SVP and Signature Bank. And a group of 11 banks, including Jp morgan Chase and Bank of America, have provided about $30 billion to First Republic Bank and then the Swiss National Bank. They also made $54 billion available to Credit Suisse as an emergency loan.

Sascha: [00:09:54] A lot of money changing hands. But surely, Darcy, this is linked to interest rates. There's so many banks that you just. Listed. This can't be sustainable. We can't give bailouts to every single bank that's in trouble. 

Darcy: [00:10:08] Yeah, there are all sorts of questions being asked at the moment about whether these bailouts leave banks without much consequence for mismanagement. If banks know that they'll be bailed out no matter what, it probably encourages riskier practices. 

Sascha: [00:10:20] Yeah. What was that quote that did the rounds? They're too big to fail. 

Darcy: [00:10:24] Too big to fail Edge. And the other question is about the flow on effects for the economy. Coming up with the cash for bailouts is going to fuel inflation. And there's a scenario where inflation becomes entrenched. If money is being handed out to rescue banks around the world. Goldman Sachs said that growing stress in the banking sector has increased the odds of a US recession within the next 12 months. The bank now believes that the US economy has a 35% chance of a recession, up from 25% before this meltdown started. 

Sascha: [00:10:54] That's what's happened to date. Darcy. But although this has been happening on the other side of the world, if there's one thing I know about financial markets, it's that we're all connected. So let's take a short break and then I want to dig into could this get worse? Are we going to feel the impacts here in Australia? Welcome back to the Dive. Today, we're talking about the meltdown of parts of the banking sector in the U.S. and Switzerland over the past few weeks. So far, all of these banks have received financial support from central banks or other investors. But I want to start with a question that is top of my mind. Darcy, will this affect us here in Australia? 

Darcy: [00:11:39] According to an RBI spokesman, no. Australian banks are pretty strong and their cash positions are well above what is required by the Australian Prudential Regulation Authority, or APRA. Obviously this can change and more interest rate hikes might make the banks less stable and if there is a global banking crisis, then I think you can expect Australian depositors to have a bit of panic too and take their money out of the banks, which could put more pressure on.

Sascha: [00:12:07] So let's go back to a question from Alia globally. Is there a limit on how many banks could get bailed out? 

Darcy: [00:12:13] In theory, there isn't. The Federal Reserve could keep printing money, but it's going to have those consequences. It would completely devalue the currency and drive more inflation. 

Sascha: [00:12:24] Which we are definitely trying to avoid. So if the governments decide to stop bailing these banks out, what happens to customer money? If I was a customer at one of these banks, is my money safe? 

Darcy: [00:12:36] Around the world, governments do guarantee bank deposits up to a certain amount, but after that, your money is at risk. We mentioned before in the US, if you've got up to $250,000 in an account insured by the FDIC, then you're safe. 

Audio Clip: [00:12:51] Americans can rest assured that our banking system is safe. 

Darcy: [00:12:55] European countries operate similar programs. In Switzerland, it's up to 100,000 CHF. That's insured. In the European Union, it's €100,000. In the UK, depositors can have up to £85,000 returned if their bank goes under. And the Australian Government also insures deposits up to $250,000. 

Sascha: [00:13:16] So in closing, Darcy, for most depositors our money is guaranteed by the government, so we're okay. But the real risk is for businesses that are customers of these smaller American banks that can't get their money out and then can't make payroll or pay other debts. And then that's going to have a ripple effect throughout the economy.

Darcy: [00:13:38] Yeah, that's the danger. And also for some borrowers, it might make it harder for them to get a loan. They stress banks, they're going to pay more attention to the credit worthiness of borrowers. So whether you're a business looking for a loan or a home buyer trying to find a mortgage, you might come under a lot more scrutiny. US Treasury Secretary Janet Yellen said last week, If banks are under stress, they might be reluctant to lend and we could see credit become more expensive and less available.

Sascha: [00:14:06] Well, Darcy, thank you so much for getting me up to speed on what's going on in the banking sector. I've been seeing a lot of headlines. If you want to keep the conversation going with us, contact us by email thedive@equitymates.com or follow or subscribe wherever you're listening right now so you never miss an episode. You're listening on Spotify. We've got a question right there in the app for you. Do you think we're going to see more banks go under? Let us know, yes or no. We'd love to hear from you. Darcy, thanks so much for joining me today.

Darcy: [00:14:38] Thanks, Sascha. 

Sascha: [00:14:39] Until next time.