The end of the beginning of the crisis is coming

No more significant banks are currently on life support and the monitoring of vital signs – like the price of credit default swaps which reflect the price of insuring against the risk of a company defaulting on their debt – is not revealing more Code Blues.

“This next phase of the crisis may come with less volatility and fewer dramatic headlines but it will nevertheless be a real crisis.”

Credit default swaps rose sharply as investors fretted about the broader system

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But that doesn’t mean the crisis is over, rather that we are moving into the next, more protracted, phases of the crisis.

The fundamental cause of this crisis was not, as in 2008, bad debts but liquidity – the availability of money – and interest rates - the price of money. These two forces exposed flaws in some regulatory regimes and risk management at individual banks.

These pressures, particularly in today’s always-on, digital world, eroded confidence in the whole financial system, creating a crisis of trust – which ultimately undid Swiss giant Credit Suisse. Banks ultimately trade in trust – I trust you will give me back my deposit with interest; you trust I will repay the loan you gave me, with interest.

The English word “credit” has the Latin root “cred” which means “believe” and is also the stem of words like credo and credentials.

These factors are already playing into the availability of credit – loans – to the entire financial system from home mortgages to high yielding “junk” bonds. Indeed, so pronounced are these effects that they are likely to limit how much further central banks have to raise interest rates to stifle inflation.

That’s because lifting interest rates constrains the availability of money by making it more expensive. If lenders are more discerning about to whom and how much they lend, it has the same effect.

Meanwhile, as interest rates rise, the amount of risk lenders are prepared to take falls. If risk free loans, say to governments for bonds, deliver almost no return, then financiers are prepared to take a lot more risk to earn something, anything. Now that lower risk returns are back at more historically normal levels, there is a much higher premium on more risk.

This is most evident in higher risk, higher return realms like venture finance, startups and small business lending. As venture capital intelligence forum CB Insights noted last week, that sector is in “freefall”.

“The global venture ecosystem continues to cool off in Q1’23 as funding decreases 13 per cent quarter-over-quarter,” CB Insights said.

Global venture funding continues to slide in Q1’23 despite Stripe’s $6.5B deal

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This contraction in the availability of credit will slow economies and inevitably lead to more risky and higher indebted borrowers defaulting. It will be exacerbated by tighter regulation and increased supervision by regulators as this latest crisis exposed too many flaws in too many places.

As ANZ chief executive Shayne Elliott told bluenotes recently "as a result of this (crisis), I can almost guarantee regulators around the world are thinking of new things they need to put in place.”

It’s already happening: the Bank of England is revisiting its deposit guarantee scheme; US regulators have said they will address holes in their system and probably try to bring more non-banks – whose systemic risks are opaque - into the fold; and European regulators have flagged tougher measures.

In a recent forum, ANZ chief economist Richard Yetsenga noted “regulators routinely apply stress tests to banks around deposit flight with an extreme test being the loss of 25 per cent of a bank’s deposits in a month. They ask, what does that mean for the bank? How will it respond?

“Well, Silicon Valley Bank lost 25 per cent of its deposits in a day. So clearly, that stress scenario is less unrealistic than it seemed when I think regulators (initially) thought about that. So, I would expect …  quite a lot of movement (on the regulatory front).”

This next phase of the crisis may come with less volatility and fewer dramatic headlines but it will nevertheless be a real crisis for those sectors of the economy which cannot cope with tighter credit conditions. Even if an economy doesn’t enter an official recession – two successive quarters of economic shrinkage – that doesn’t mean businesses won’t fail, households won’t default or markets won’t gyrate.

Financial markets are complex entities, they are forward looking and the more uncertain the outlook the more market responses over-react to each piece of news.

The International Monetary Fund was frank about the threat at its latest annual forum.

“Our latest Global Financial Stability Report shows that risks to bank and nonbank financial intermediaries have increased as interest rates have been rapidly raised to contain inflation,” the IMF said. “Historically, such forceful rate increases by central banks are often followed by stresses that expose fault lines in the financial system.”

Rate hikes and financial stress
Financial strains have typically followed periods of elevated inflation and rapid interest-rate increases.

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Unsurprisingly, the IMF also flags more official intervention in markets – and a consequent tightening of credit availability.

“Faced with heightened risks to financial stability, policymakers must act resolutely to maintain trust,” the Fund said.

“Gaps in surveillance, supervision, and regulation should be addressed at once. Resolution regimes and deposit insurance programs should be strengthened in many countries. In acute crisis management situations, central banks may need to expand funding support to both bank and nonbank institutions.”

In his recent address to the National Press Club, the governor of the Reserve Bank of Australia, Phillip Lowe, summarised the lessons – so far – of this crisis. His first point was the speed, given digital banking, social media and smart phones did indeed mean runs could happen in seconds.

“So what do we do? How should we think about bank liquidity and what are the regulatory responses to that?” he asked. He supported calls to look at the management of interest rate risk – which Lowe noted was robust in Australia – and deposit insurance schemes given capping insured amounts to avoid moral hazard hasn’t worked in the real world.

Faced with choosing between potential panic and guaranteeing deposits to avoid it, governments and policy makers inevitably see inflicting lessons in risk management as less desirable than creating moral hazard.

“But most importantly – and this is one that we do well in Australia – is making sure that a supervisor does first-rate supervision,” he concluded. “It’s not just about black letter regulation; it’s about supervision.”

As the long tail of this crisis unwinds, we must remember we are no longer in Kansas even though the tornado appears to be easing.

To quote Coolabah Capital’s Chris Joye: “Many assumed the search for yield came with no risk in a low-rate world. But we are watching the downside materialise. Global corporate defaults are running at their highest level since 2009. US corporate insolvencies are the loftiest since 2010. In Australia, the RBA reports that 15 per cent of all borrowers could have negative cash flows while 16 per cent may not be able to refinance existing loans.”

Andrew Cornell is Managing Editor of bluenotes