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It’s Turmoil, Not a Crisis

It's Turmoil, Not a Crisis

For a week and a half, investors have wondered how the Fed would balance competing inflation fears and a bank panic—answer: hike rates by a quarter point.

It isn’t necessarily bank failures that pose economic risks because they constantly happen, even during bull markets and economic expansions. On average, a handful of banks collapse each year during good times and more than 100 in bad economic times. Knowing bank failures are relatively common helps us understand they are not inherently bearish for broader markets. No, the real issue is when banking officials respond inconsistently, making it difficult for investors to identify and price risks.

Cue Credit Suisse, which sold to UBS for a sliver of its value on Sunday after flirting with failure several times last week. The sale isn’t the issue. The problem is how regulators imposed losses on Credit Suisse’s investors, which caught many people off guard while providing equity investors some (minor) compensation, but wiping out holders of certain bank bonds. Many fear this could establish a scenario throughout Europe where equity investors outrank selected bondholders in the event of a failure. But don’t worry; the Credit Suisse situation isn’t likely the new design for European banks. Even though Switzerland isn’t in the EU and Credit Suisse wasn’t subject to the EU’s strict (on paper) bank resolution rules.

After the Great Financial Crisis (GFC), Credit Suisse was labeled a Globally Systemically Important Financial institution (G-SIFI) due to its size and deep global interconnectedness. Consequently, despite years of noticeable mismanagement, regulators kept it alive, and bond investors—seemingly seeing the bank as too big to fail—continued providing capital. Then last week, Credit Suisse had some bleak results in their delayed annual report.

Now it gets fun. Generally, when a big, solvent bank buys a failing bank, the sale price is a token. Example: HSBC bought Silicon Valley Bank’s UK subsidiary for £1. Spain’s Banco Santander bought the failed Banco Popular in 2017 for €1. But this time, UBS paid 3 billion Swiss francs in stock, providing Credit Suisse shareholders 1 UBS share for every 22.5 Credit Suisse shares they owned. This purchase wouldn’t be such a big deal, but Credit Suisse had not failed yet; it happened after Credit Suisse wrote its “contingent-convertible” bonds down to zero, wiping out those creditors.

As readers know, it doesn’t work this way, the standard practice is shareholders take the first round of losses, and the losses imposed on creditors only come after common stockholders have been wiped out. This practice makes sense. Shareholders own the business, and when a business value goes to zero, it often still owes people money. The remaining assets are sold, and proceeds are used to pay off the outstanding debt. This order is determined by a pre-set bankruptcy law to dictate the order creditors receive money. It is similar for banks; bank resolution procedures set by regulators determine the creditor order.

So, the recent unconventional bank failure discrepancies could persuade banks to take less risk for the time being because inconsistency instills fear. Even if banks don’t deleverage, they could easily reduce lending, which could slow economic growth. All of this will take time to work through the system, but it will be worth keeping an eye on future data reports.

Public fear is currently high, but the reality is far better than many perceive. Even if reality doesn’t go well from here, all the markets need to see is a slightly better future than currently expected. Anything shy of an all-out banking disaster could qualify as a positive surprise and push stocks higher. Once the hysteria fades, no one will remember any of this, just like no one remembers that more than a hundred banks failed a year for years after the GFC. So, let’s continue monitoring the condition, but don’t extrapolate recent banking issues into continual pain for global markets. What you should be thinking about is that when others are fearful, you should get greedy.

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