Until something breaks…v2

Since we wrote the first update on the banking crisis on Sunday evening a week ago, things have developed further. On aggregate, progress has been made on preventing a global bank run and on re-assuring retail clients and investors. Still, important questions remain both about how future bank collapses will be handled and about how well central banks and regulators understand the situation, as well as on how much liquidity is being tightened by market events and pricing. In addition, there are specific questions on the situation and the decisions made in Switzerland. In the following note, we will lay out our view on the situation and the likely, if still highly uncertain, development.

Initially, let us briefly summarize the market developments since our last note. In a broad sense, markets are up. European equities and especially banks suffered last week, but global equities were lifted by US equities. This move up was to some extent driven by official action to stem the crises at SVB and Signature Bank, but probably to a larger extent by a view that less monetary tightening will be needed, and the discount rate will therefore peak at lower levels. US government bond yields tanked along with Eurozone yields declining dramatically. The US 2-year treasury yield, which was down 40bps last Sunday, is now more than 100bps below its recent peak (see Figure 1).

Already on Friday we started receiving requests from the international financial press to comment on the situation in Switzerland and its likely global consequences. By Sunday evening a solution was found whereby the SNB, FINMA and the Swiss government had brokered a merger between CS and UBS. According to the Swiss government, this is not a bailout, but rather a commercial solution. What is clear is that Credit Suisse collapsed and that the government and SNB are providing the “resource in short supply”, namely liquidity and loss protection, without the compensation priced in the market. So as Mohamed El-Erian stated on Bloomberg, it looks like a bailout.

From a market perspective one can distinguish short term and longer-term effects:

- The worst-case scenario of the “bank walk” on CS escalating into a bank run has been avoided. This is a short term and long term positive, but with the caveat that the noise on the way has increased the risk of a market panic among retail investors and the probability of any additional bad news triggering a risk off trade across the institutional market space.

- The “new” UBS bank is backed by SNB liquidity facilities and should be viable. In any case, we think the statement from the government and SNB amounts to a Swiss version of “whatever it takes”. Also, the safety of Switzerland as a booking centra is maintained.

- Still, and of potential long-term importance, the Swiss press, the public and the parliament are demanding explanations as to what happened and why, after years of scandals, mismanagement, public scrutiny and share price losses, FINMA and SNB did not bring CS under control. And to why emergency legislation had to be enacted over the weekend.

- From an investor perspective, the collapse of the second globally important bank in Switzerland in two decades means that trust in the institutional set-up around Swiss banking is hurt. The issue is exacerbated by the fact that it was stated on the SNB website as late as Wednesday, 15th March, that CS is well capitalised while on Sunday, 19th of March, $16bln of AT1 capital was supposedly wiped out.

Related to the structure of the plan, there is now additional uncertainty on what will happen to bondholders in other potential cases across Switzerland and Europe. If central banks and regulators behave arbitrarily, it leads to uncertainty about their understanding of the situation for banks. The SRB, EBA and the ECB highlighted and attempted to contain this risk on Monday, stating that “The European banking sector is resilient, with robust levels of capital and liquidity” and ”In particular, common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier One be required to be written down. This approach has been consistently applied in past cases and will continue to guide the actions of the SRB and ECB banking supervision in crisis interventions” (our highlight).

There is also some uncertainty as to how well the world’s central banks understand how much tighter liquidity condition are and take this into account. Last Thursday, the ECB moved ahead with their decision to hike 50bps. A decision apparently made before the market turmoil and, as specifically highlighted in the statement, based on economic forecasts prepared before the events the prior week. Why these forecasts had not been updated is beyond this author, but the ECB’s chair praise for ECB staff sounded strange and could have been used as a script for how to sound more human than the current French president in his ongoing domestic struggle. Still, while the hike could be seen as hawkish, the press conference was dovish. There were a lot of promises of help in case of liquidity problems at banks and there was no guidance on future hikes. German 2-year government yields initially increased by 16bps but, as seen in figure 1, have since declined showing the volatility and risk of high-grade bonds in this business cycle.

On Thursday evening it was announced that 11 large US banks, led by JPM and BofA, put together a support package for First Republic Banks. As reported on Bloomberg, this was done under pressure from the US government. The initial effect was positive, but this did not last, and the equity price continued down Friday and Monday. So, a new program or a winddown is likely to be needed. This could possibly be with an enforced solution, like in the case of Signature Bank, or a more voluntary version.

As the next step, in the US the clean-up is expected to continue. As the Treasury, FDIC and the Fed have now declared this crisis systemic, there will be more tools available to handle a continuation of the crisis and, as a minimum, we expect news on the banks affected in the coming days. On Wednesday evening this week, we will know if the Fed will hike and if they will moderate their future hiking path as priced over the last week. As with all financial market crises, we believe that it is in the credit market we will see if the situation across global financial markets can be contained. As long as it is only specific banks, like SVB and Credit Suisse, who see their equity wiped out, and only the European AT1 market is broken, the effects can be contained in the financial sector. In this context, the recent news surrounding both Signature Bank and First Republic Bank look positive if still not fully sufficient in the latter case. If investment grade bond and high yield bond spreads widen much beyond peaks from last year, the aggregate levels of borrowing costs risks becoming a self-reinforcing crisis-inducer and a recession would be likely.

In summary, eight days have passed since our last note on this topic, progress has been made, mainly in the US. The ECB seems confused and dovish, and the Swiss National Bank has provided guidance, liquidity help and less helpful statements. People around the world have now been alerted to the fact that they may need to act on bank failures. The implication is that mistakes are becoming more costly, but less likely. If the authorities keep the balance in action and statements in the coming days, we don’t think markets will fall much further but we need to see continued action from policy makers and we will remain ready to change positioning as and when needed.

Best regards,

Mads N. S. Pedersen