The Bid Episode 120: Why are these market events different from 2008?

Episode Description:

As central banks have been trying to control inflation with the fastest rate hikes since the early 1980s, we've begun to see some cracks in the financial system. Most notably the recent collapse of two US regional banks, Silicon Valley Bank and Signature Bank, and the evolving situation around Credit Suite's liquidity position. Alex Brazier, Deputy Head of the BlackRock Investment Institute is here to tell us why this crisis is different from 2008 and what investors can expect to see from central banks in an effort to control inflation and protect the financial industry.

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<<THEME MUSIC>>

Oscar Pulido: Welcome to The Bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido.

As central banks have been trying to control inflation with the fastest rate hikes since the early 1980s, we've begun to see some cracks in the financial system. Most notably the recent collapse of two US regional banks, Silicon Valley Bank and Signature Bank, and the evolving situation around Credit Suite's liquidity position.

Here to explain what happened and what investors can expect, I'm pleased to welcome Alex Brazier, Deputy Head of the BlackRock Investment Institute.

Alex, thank you so much for joining us on The Bid.

Alex Brazier: Hi Oscar. Thanks very much for having me.

Oscar Pulido: Alex, we're both sitting here, it's Thursday, March 16th, financial markets have been spooked by events, in the banking industry on both sides of the Atlantic. so, can you just explain what's happening and what led to this crisis?

Alex Brazier: It's been, an eventful week, I suppose. The story goes back some way, but before we look in depth at the last week, I think it's useful to remind our listeners that really what's happening here is that the fastest rate hiking cycle since the 1980s was clear that was always going to cause some economic damage and expose some cracks in the financial system.

And what we've seen in the last week is those cracks actually beginning to appear and as we'll come on to discuss, that means more of the economic damage is yet to come.

So that's really the scene setter, the sharpest fastest rate hiking cycle since the 1980s. But then what actually happened over the last week, well, really useful to talk about three things that have happened.

The first is what happened with, Silicon Valley Bank and US regional banks. Then what did the authorities do? And perhaps, the third thing, bringing us up to date is how it's rippled across the Atlantic to European banks.

And starting with the first of those, US regional banks. What really happened at Silicon Valley Bank, well, it was a bit of an outlier in two important respects. The first is that it had a very large share of its deposits, greater than $250,000. So, they're uninsured deposits, and those are typically more flighty and more likely to, be withdrawn in stress than insured deposits. And the second thing it had in which it was an outlier, was that it had a very large book of US treasuries and mortgage-backed securities. And of course, as interest rates have gone up a lot over the last year, the market value of those securities has fallen a lot.

Now, Silicon Valley Bank hoped that it wouldn't have to sell these securities. It hoped to just hold them until they matured. But to link these two outlying characteristics together, a lot of its depositors were spooked and asked to withdraw their money, and as a result, it was forced to sell some of these securities at today's market prices and realize some of the losses. That meant that more depositors withdrew their money as the bank realized some losses. and so, it entered this kind of spiral, downward and the authorities then stepped in to take control of what was at that stage, a failing bank. The issue of course, then prompted depositors, particularly uninsured depositors, to withdraw money from other regional banks like Signature Bank, and the authorities stepped in there, as well.

So, what did the authorities do when they stepped in? Well, they've seized control of these banks written down the equity, and they've protected the insured deposits as they normally would. But very importantly in these cases, they've also used what's called a systemic risk exemption, which allows them to protect the uninsured deposits as well.

So, these banks failed, over the weekend and on Monday morning, all the depositors. Whether their deposits were insured or previously uninsured had access to their money on Monday morning. So, the authorities have dealt with these banks not by giving a bailout to the shareholders. This isn't shareholder friendly, but by protecting, the depositors in those banks, so that was the US authorities.

And then the third aspect really of what's happened in the last week is that the crisis has rippled across the Atlantic. And it's not that European banks have in any way the same underlying issue as these regional US banks. And they're not directly connected either, but there is a channel of contagion, which is that following what happened in the United States. Markets are now applying greater scrutiny to banks around the world, including in Europe, and they're applying greater scrutiny to banks that have challenges or even where those challenges have been going on for years.

And as a result, we've seen market confidence and volatility in Europe, we've seen the Swiss National Bank step in with liquidity support for one of its banks, Credit Suisse, and so we see how this evolves from here.

But it's important to note that we don't have the kind of contagion channels that we had in 2008, but there is still this contagion channel across the Atlantic where markets are now looking at banks differently even where they don't have new challenges.

But I just go back to the root cause of all of this, which is the fastest rate hiking cycle since the 1980s, which was always going to cause some degree of damage and expose some financial cracks. And that's really the underlying root cause of everything that's gone on in the last week.

Oscar Pulido: Alex, you mentioned 2008, which is hard to believe it's a decade and a half ago, but the headlines of the past week, for those of us who lived through 2008 and that crisis, it's hard to not try and draw comparisons, and during that financial crisis, you were part of the team concerned with financial stability at the Bank of England, so you were in the thick of it then. How do you see what's gone on over the past week compared to what happened in 2008?

Alex Brazier: There are uncomfortable echoes of course, anytime you get any sort of problem in the financial system but there are some really important differences this time, which mean it's not quite the same.

 The first really important difference going to what's happened in the US is that, back in 2008, the issue was really exposures on banks, balance sheets, subprime mortgage exposures that were really opaque, really difficult to find where they were, figure out how much they were worth... and so there was a lot of uncertainty across the banking system about who was holding the problem assets. And so, the contagion spread through the system as people lost confidence in all banks.

And the only way to solve it was effectively to dig into banks’ balance sheets with the stress tests at the time, and provide state recapitalization, taxpayers money, into banks that it was found had a hole in the value of their assets.

I think what's different this time in an important respect is that the assets at the heart of this in the US banking system, far from being opaque are actually the most transparent and easy to value of the lot. It's US treasury bonds and mortgage-backed securities. And so, it's very clear to assess where the losses are on those assets and who's holding them.

And that makes it very different in an important respect. And it's clear when you do that, that Silicon Valley Bank, for example, was a very big outlier. Relative to the whole of the banking system. So that's a big difference from 2008, we've gone from opaque losses. To very transparent, losses on some of these really transparent securities.

I think the other thing that's really different is where the system starts the banking system in particular, in terms of how much capital it's got, and that capital's there to absorb losses while protecting the deposits. So, we've started in a position where banks have lots more of their own shareholders money on the line than they did back in 2008.

And so even though pretty much all US banks hold US treasuries and mortgage-backed securities, and so they will have incurred some mark to market losses as interest rates have gone up over the last year.

The losses over the system as a whole are significant, but eminently manageable within the capital base that US banks have now got. So unlike 2008, this isn't a problem with asset values, that's going to overwhelm the kind of capital base of the whole banking system.

So those are two big differences, from 2008. And I think the third big difference is that the authorities now have more tools to deal with this.

We saw last weekend the Fed stepped in very quickly. I think because it was able to assess the problem and mark down assets and figure out who had the issues.

The Fed came in very quickly with a new lending facility, the bank term lending facility, to effectively support banks that were experiencing a withdrawal of deposits. So, where this had a knock-on effect from Silicon Valley Bank to some of the other regional banks, people with withdrawing their deposits to put them into bigger banks. The Fed was able to launch a facility to basically make that process run much more smoothly and stop regional banks needing to undertake forced sales of some of these securities like US treasuries and mortgage-backed bonds.

So, the authorities have more tools, they also now have more to deal with banks when they fail in a way, they didn't in 2008, when they faced a kind of invidious choice between bankruptcy, which of course means depositors money is locked up, and bailout.

This time they've got so-called resolution tools to deal with failing banks. So, in those three important respects, transparency of where the problem is, the ability to use the tools they've now got and a bigger capital base in the banking system. That makes this a very different proposition,

Oscar Pulido: And maybe specifically on that third point that you mentioned central banks and the toolkit that they have now, which is partly a learning from 2008. So, you've mentioned the Federal Reserve, putting that toolkit to use. You also mentioned the Swiss National Bank, which is acted as a backstop to one of their important financial institutions.

So, are we okay now or does this have ripple effects from a macroeconomic perspective going forward?

Alex Brazier: Yeah. I think despite this being different and despite all the tools at their disposal, this will have ripple effects for the economy, in the US and in Europe actually. And why is that when we're in this different situation? Firstly, in the US regional banks are still under pressure and they'll be under pressure for two reasons.

The first is that despite the way these failing banks were resolved over last weekend, Depositors are still withdrawing their money, in some cases, to place it with some of the bigger banks. So regional banks are finding it more difficult to raise deposits and fund their lending.

Now, as I said, because the Fed has launched this, bank term lending facility, that process can be much smoother than it might otherwise have been but nevertheless, what we're going to see is some of the regional banks need to adjust their businesses, shrink their balance sheets, and that means. Tightening their, credit supply conditions, the loan officers at these banks won't be extending lots of credit now, and that means for the economy as a whole, a tightening in credit supply means less credit available.

Now, that's going to have an economic effect. It's going to tighten financial conditions for businesses and households and that's going to help to slow the economy in the way the Fed's rate hikes were actually designed to do.

 That's one ripple effect onto the economy and I think in Europe, a similar thing's going to happen. So even though it wasn't the same underlying problem, because of this contagion channel where markets are applying more scrutiny to banks, it is more costly for banks to raise equity, to issue debt. And that's going to be passed on to lending conditions to the broader economy.

And it's also going to tighten conditions in financial markets because those banks are going to be less willing to make markets, and act as dealers in those markets.

So financial conditions for the economy are going to tighten, not on the scale that, they did in 2008. And in a way, what we're seeing here is just the normal response to a rise in interest rates. It's happening through some sudden channels, but I go back to this point that the ripple effects here are really the effects of the sharpest rate hiking cycle since the 1980s, but it is going to affect economic activity through these channels.

Oscar Pulido: And so that fastest rate hiking campaign that we're seeing since the 1980s, what do central banks do now? Do they take a, pause, with hiking rates and remain in this, whatever it takes type of mode to backstop financial institutions?

Or do they continue with hiking rates to combat what has been a, an inflationary background, really globally?

Alex Brazier: This is a very different episode to 2008 in one other respect as well, which is that we go into this with central banks facing an inflation problem. Both the Fed and the ECB have got the problem of stubbornly high core inflation.

So, inflation's come off its highs, but it's still not on track either side of the Atlantic, to actually come down and settle close to their 2% targets. So, they were needing to raise rates, slow their economies probably generate recessions if they wanted to get inflation all the way back down to their targets, and that's a very different situation to the one we were in 2008 and the one we've been in every kind of financial wobble over the last 30 or 40 years, in fact.

So, the playbook where central banks respond both with tools to address financial problems like lending facilities like we've seen this week, and rate cuts isn't on the table this time. What we think they'll try and do, to the extent they can, is effectively separate two issues separate.

On the one hand, maintaining financial stability, where they'll be using lending facilities in the way they've done over the last week, and monetary policy, interest rates, where they'll be looking to deal with their inflation problem.

And in a way what the Bank of England did last September is a good model for this, a good guide for this, faced with problems in the UK gilt market, it launched one operation, some temporary purchases, of gilts to deal with that financial problem, whilst at the same time raising interest rates to deal with its inflation problem.

And that is the playbook we're more likely to see here at this stage, central banks using lending operations to deal with financial issues whilst using interest rates to continue to deal with their inflation issues.

Now that's very different, and we've seen actually the ECB just before we've recorded this, go through with its earlier guidance that it would raise interest rates by 50 basis points. this month it's gone through with that suggesting its use of interest rates isn't being diverted to addressing other issues in the banking system. That said, with credit conditions tightening as a result of these issues in the banking system, that's effectively going to do some of central bank's work for them. It's going to tighten credit conditions; it's going to slow the economy. Central banks won't need to raise interest rates as much as they otherwise would've done to deliver the economic outcome they're looking for- which is a recession and getting inflation down.

So, they're going to do a bit less than they would otherwise have done. So, more rate hikes, but not as many as we might have seen. But the big point here is that they won't be coming to the rescue of markets, in our view, with aggressive rate cuts because of the inflation issue, that they're facing and that's a big difference, I think to the past.

Markets have priced in now some big rate cuts over the course of the year, but as it stands, they're likely to try and maintain this clear separation of two sets of tools, two targets, lending facilities for maintaining financial stability and interest rates and monetary policy for dealing with inflation.

Oscar Pulido: The scenario you're describing sounds like central banks are going to be multitasking for the foreseeable future. Alex, I know you've had a busy week, thank you for spending part of it with us here on The Bid

Alex Brazier: Thanks Oscar for having me.

Oscar Pulido: Thanks for listening to this episode of The Bid. Subscribe to The Bid wherever you get your podcasts.

This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities, funds or strategies to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The opinions expressed are as of the date of publication and are subject to change without notice. Reliance upon information in this material is at the sole discretion of the listener. Investing involves risks. BlackRock does and may seek to do business with companies covered in this podcast. As a result, listeners should be aware that the firm may have a conflict of interest that could affect the objectivity of this podcast.

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