This is the right time to tell the story of how I nearly started a banking crisis. In the summer of 2007 I started work at Credit Suisse, as the tremors of the credit crisis were building. I finished a long day’s work with an interview with Bloomberg TV USA where the topic of conversation was an alarming sell-off in banking stocks. At the time I thought I was being very careful with my wording, stating that the ‘market is treating banks as if they were toxic’. Given the broad based denial of an impending financial crisis, such a remark was – whilst measured – a step well beyond the consensus.
To my misfortune the Bloomberg new headline writers picked up on it. By the time I had crossed London on my way home, my Blackberry (remember those) was buzzing with messages and emails. The headline writers had taken my remark and turned it into the headline ‘Credit Suisse says banks are toxic’.
Given that a good many of the calls and messages were from people from the very top of the bank, I had the good sense to get back to the office and ‘put the fire out’ (Bloomberg took down the headline). From that day, I have a rule of thumb that crises need to be quenched within an hour. Naturally, the fate of the banking sector through 2008 established the genius of my initial remarks!
Silicon Valley Bank
Now, we are once again into the breach. Multiple banking crisis within a week, and the will of central bankers bending to accommodate them. Whilst there is a lot of ink being spilt on the financial plumbing of Silicon Valley Bank and Credit Suisse, one suffered a crisis of its customers and the other a crisis of governance and confidence, they are simply two weaker links in a financial economic system that is operating under the enhanced barometric pressure of high interest rates.
That much of the financial system, growth companies, bankers and investors have not operated in a realm of persistently high rates suggests that they are now fish out of financial water. To that end we have now entered a phase in market behaviour where monetary policy is ‘breaking things’.
This ‘breaking things’ regime operates in a narrow corridor where robust parts of the economy (strong labour markets) produce pressures that beget a monetary response, that in turn breaks rivets in the economic machine, to which the solution is more liquidity. The longer the corridor the more quickly concepts of moral hazard are jettisoned, but also the more violent the market reactions, and the faster they occur.
In the ‘breaking things’ financial world the first thing to break is reputations. There is a long list here – the libertarians of Silicon Valley who disavowed bailouts a year ago, Barney Frank the rule-maker now caught offside as a director of Signature Bank, regulators and bankers in general.
Relatedly, there is nothing quite like financial pain to unmask innovation as financial and operating leverage, and this reality will ripple through Silicon Valley in coming months. We can also expect economic history to become fashionable, and in coming days expect to see plenty of references to Bagehot and the ‘Overend & Guerney’.
Economically, two broad issues matter. The first is reflexivity– a term coined by George Soros and given depth by Avinash Dixit who used the term hysteresis to describe long run effects of macro shocks on investment. Should more banks start to ‘break’ then this will produce a contraction in lending and a downturn in activity – notably we are seeing some inflation related indicators dip in a manner consistent with the start of a recession.
We may well be into a recession but I think the much more interesting and enduring effect will be a pronounced winner/loser effect across countries, companies and banks – in favour of those that are cash rich, and in the case of banks, systemically important.
We wrote about this last week in the sense that Defi (decentralized finance) and the Metaverse were recently thought of as ‘worlds apart’ but are now simply addendums to the ‘real world’. In that way the ‘old system’ is drawing them in.
Commensurately, there is now a similar drift within banking, where older, large (systemic) banks are seeing inflows of depositor cash from smaller banks. If this persists it can weaken the outer edges of banking – especially in the US – where regional, community and specialized banks see deposits run down. It may be that the only response to this is for the government (FDIC) to issue much higher and broader deposit insurance, or else face the consequences of ‘banking inequality’, but I think such a policy move is unlikely.
This is just one element of a growing policy crisis that is born out of the consequences of tighter monetary policy, rising credit risk and now, a crisis of ‘suspicion’ regarding financial institutions. A complicating factor is that the Treasury is running out of cash as the debt ceiling limit nears (America now spends more on debt interest than on its military).
In a normal business cycle rates start to fall as credit risk rises, but it will not naturally be the case this time- hence the idea of the narrowing policy corridor and the necessity that things get ‘broken’. The best indicator of this is bond market volatility, which is now at its highs of the past decade.
Next week will be an important marker in determining whether the crisis of confidence in banking, which has already happened at lightning speed, becomes contagious and, whether it alters the course of monetary policy (the Fed meets on Wednesday) ….which like 1998, produces the next bubble.