By David Kindley, Market Strategist at Orbex
Fears of a global banking crisis are making headlines these days, after the collapse of three US banks and Credit Suisse’s takeover by UBS. The level of economic uncertainty is now as high as it has been since the depths of the pandemic, with many fearing a repeat of the 2008 Global Financial Crisis – which incidentally was also brought about by the collapse of overleveraged financial services firms and banking companies.
But before we explore whether these fears are justified, we need to consider the events that led us here.
A historic inflation surge
When Covid-19 hit and global lockdowns came into effect, Central Banks started printing money, lowering key interest rates, and issuing stimulus checks to help keep the economy afloat. In this ultra-loose cheap money environment, digitalization and innovation took center stage with retail investors, hedge fund managers, tech companies, and even banks taking on cheap loans and overleveraged positions to help boost their profit margins.
As the economies reopened and as a result of all the disruptions in supply chains and the ongoing conflict in Russia-Ukraine, prices for basic goods and services skyrocketed.
The ultra-loose monetary policy of 2020-2021 drove inflation to a 40-year high of 9% in the US, ultimately forcing the Federal Reserve to rush into its fastest hiking cycle in modern history and setting off a process of “deleveraging” the economy.
The price of risk
As Warren Buffett once said: “Only when the tide goes out do you learn who has been swimming naked.” Unsurprisingly, the first companies that defaulted on their loans or were forced to file for bankruptcy because they did not have enough capital on hand to cover customer withdrawals were investment companies and crypto exchanges that had re-invested their client funds and could not liquidate their positions as stock, crypto, and long-maturity bond prices plummeted.
When the Silicon Valley Bank collapsed on March 10 however, the world was alarmed, Signature Bank soon followed leaving crypto companies unbanked, and by the end of the same month, Credit Suisse was taken over by UBS.
Meanwhile, SVB-buyer First Republic and Germany's largest lender Deutsche Bank came under immense sell pressure and their stocks slumped amid fears over the banking sector's resilience. We also saw some bank runs in medium-sized banks with depositors trying to get their money in cash or transfer their money to bigger banks. But why exactly did this all happen?
A balance sheet recession
Much like tech and investment companies, banks invested a large proportion of their deposits in held-to-maturity securities or bonds. This led to their collapse when investors sought to withdraw their money at the same time. Combined with the drop in stock prices, analysts fear that this may lead to a “balance sheet recession.”
In a balance sheet recession, sectors of the economy stuck with bad assets from a collapsed bubble are forced to sell, pay down, or otherwise dispose of those assets, in order to avoid bankruptcy. This in turn brings the net new borrowing grind to a halt. Given the latest banking crisis, there’s a good chance we will experience a similar deleveraging state.
How bad is it?
Recoveries from balance sheet recessions primarily involve debt paydown and are usually painstakingly slow. Back in 2008, the world underwent a global financial crisis after cheap credit and lax lending standards fueled a housing bubble. When the bubble burst, major investment banks were left holding trillions of dollars of worthless investments in subprime mortgages. The bankruptcy of financial services firm Lehman Brothers in September 2008 was the climax of this housing crisis.
While the economic conditions that led to the 2008 global crisis at first glance look very similar to what we are experiencing today, a repeat of the 2008 crash is not very likely. For one, today we have more regulation and oversight in place resulting in much less risk in the banking system than 15 years ago.
There are also investor compensation funds in place to guarantee all deposits up to 100K in the EU and up to 250K in the United States. In the case of the SVB collapse, the Federal Deposit Insurance Corporation (FDIC) stepped in on March 13th, 2023, to guarantee that all depositors of the institution, regardless of account size, would be made whole.
The Fed remains hawkish
On Wednesday, March 22nd, 2023, the US Federal Reserve raised interest rates by 0.25%, reiterating the need for tighter credit conditions for households and businesses in order to bring inflation under control.
Not only did Fed chair Jerome Powell firmly dismiss market bets for a rate cut in 2023, but he also hinted at another 0.25% increase within Q2. At the same time, Capital Economics pointed out that deposits across all the banks have fallen by $663 billion in the past year as customers search for higher yield.
A fragile recovery
As smaller banks collapse, major banks are bound to become even more conservative in their lending.What it all comes down to is that less lending will lead to less spending and, by extension, less economic growth. Even if market volatility subsides in the coming weeks and months, less credit flowing into the economy means lower growth.
In fact, US and EU growth is projected to remain at below-trend rates in 2023 and 2024. At the same time, inflation is projected to trend lower in the next two years and if the Russia-Ukraine conflict ends, energy and food prices will eventually drop. When that happens, the Fed and other Central Banks are bound to start quantitative easing and we will see rates drop and lending ease, which will in turn mark the end of the current economic contraction cycle.
About the Author:
David Kindley, Market Strategist at Orbex
Market Strategist at Orbex David Kindley is a renowned fundamental analyst with over 10 years of trading experience in the financial markets. With a keen eye for macroeconomics and a special focus on trading psychology, David is passionate about helping everyday investors make informed trading decisions through his thorough research and analysis.
