We should expect more financial shocks until the message sinks in

Swiss regulators have tossed nitroglycerin onto the global financial fire. They have also committed shameless expropriation. So much for the safety of Zurich.

The total wipeout of $US17 billion ($25.5 billion) of Credit Suisse’s tier 1 bonds renders the convertible debt market in Europe almost uninvestable. These junior bonds ought to trump equities in market hierarchy. Clearly they do not.

Fed chief Jerome Powell will announce the central bank’s rates decision on Thursday morning AEDT.Credit:Bloomberg

The Invesco AT1 capital bond fund, which pools such bank debt from the likes of Barclays or Credit Agricole, crashed by 18 per cent as investors digested the terms of the rescue deal for Credit Suisse. It recovered after a startled European Central Bank rushed out a reassurance that no such atrocity would happen in the eurozone. But it did happen to AT1 bondholders of Spain’s Banco Popular in 2017. When push comes to shove, it is easier to fleece the sophisticated foreign funds that buy these instruments than to wipe out retail shareholders.

There is a reason why regulators were loath to impose haircuts on bonds at the onset of the eurozone debt crisis. Merely to talk about writedowns risked instant contagion. You can date the moment that the small Greek crisis turned into the larger Italian and Spanish crisis, and became an existential threat to Europe’s monetary union. It was when Angela Merkel and Nicolas Sarkozy in October 2010 opened the door to haircuts on sovereign debt. Investors hurried to the exits, sauve qui peut.

The justification for selling Credit Suisse at 7 per cent of book value and vaporising its bonds is that the bank is in worse trouble than supposed. Either Swiss regulators are exaggerating – in order to expropriate $US17 billion (3 per cent of Swiss GDP) – or global monetary tightening has already done widespread systemic damage.

What is shocking is that a large and historic global bank could disintegrate in days. Regulators seem to have discovered a thicket of undisclosed losses. Credit Suisse had larger capital buffers than most global banks. That Maginot Line so favoured by Basle regulators proved next to useless.

It was the same lightning devastation of four US banks. Silicon Valley Bank (SVB) lost $US42 billion of deposits in a single day on March 10. The sequence of pre-Lehman financial tremors in 2007 – Icelandic banks, Bear Stearns, Northern Rock – seem almost leisurely by comparison. Our instant digital culture has accelerated the mechanisms of a modern bank run.

The prevailing narrative is that SVB was a maverick with over-exposure to the US tech bubble and to interest rate risk from US Treasuries, and too reliant on large uninsured depositors. This is true as far as it goes (not far) but it evades the larger issue.

“SVB was a good bank. It did what it was supposed to do: invest in mortgages and Treasuries,” said Professor Larry Kotlikoff from Boston University. It chose to park excess deposits in AAA bonds for safe-keeping after stepping back from lending to Silicon Valley as the tech cycle rolled over. It had the best collateral in the world. Yet it blew up suddenly because it had not taken out adequate hedge protection against breakneck monetary tightening by the Federal Reserve. It was forced to crystallise paper losses that were exempt from rules on mark-to-market pricing.

Credit Suisse has cut thousands of jobs globally and is splitting its investment bank which will trade under the Credit Suisse First Boston name.Credit:Bloomberg

That ought to give pause for thought. The Federal Deposit Insurance Corporation says US banks were $US620 billion underwater on bond holdings as of December. How many others risk a bank run the moment they have to start selling any “safe assets” at a loss?

Republic Bank also faced deposit flight and had to be rescued by a $US30 billion whip-around among the big banks. This has not yet done the trick. The bank is not a basket case. It passed the Dodd-Frank stress test: ergo, regulators concluded that its portfolio of mortgage loans could weather the housing slump.

Over three days last week, the Fed increased emergency loans of different kinds from almost nothing to $US318 billion. “To put that in context, it’s a far more severe liquidity crunch than at the start of the pandemic and not far off the financial crisis peak of $US437.5 billion in mid-October 2008,” said Paul Ashworth from Capital Economics. In parallel, the Federal Home Loan Bank tapped the US Treasury for $US250 billion of liquidity to alleviate acute stress among regional and community banks.

These rescues have become necessary because the US financial system cannot withstand the pace of rate rises and quantitative tightening (QT) by the Fed. As long as the Fed thinks its chief task is to crush inflation, the banking crisis will continue to escalate.

Philip Turner, a former senior official at the Bank for International Settlements, said these bank failures are not “one-off” upsets. The pathology is more fundamental. “The scale, opacity, and interconnectedness of interest rate exposures remains the major systemic risk right now. This is the inevitable consequence of monetary policies pursued over the last 15 years. Central banks bought long-term assets for more than decade in order to depress government bond yields well below sustainable market levels,” he said.

“Regulators adopted rules and practices that induced banks, pension funds, and insurance companies to take on even more rate risk,” wrote Prof Turner in the journal Central Banking.

It worked marvellously at first by reinforcing quantitative easing (QE). The nefast consequence is that benchmark “safe assets” have themselves become the transmission channel for financial shocks. Ah, the implacable law of unintended consequences.

Professor Turner is not saying that QE was wrong. The error was to persist too long, and at the wrong calibration. We are stuck in this brave new world. Central banks have swung from frenetic money creation in 2020-2021 to the monetary death march of 2023, with all key measures of the money supply flashing red warnings in America and Europe.

The best we can hope for is a controlled hard landing but that requires a circuit-breaker. At a minimum, the Fed should halt its cycle of rate rises and suspend QT until the money growth recovers. The ECB should stop beating its chest until it is clearer how much damage it has already caused.

Will either act in time? Probably not. Central bankers have yet to acknowledge that the money supply is dangerously out of kilter. So brace for a long hot year of financial accidents until they get the message.

Telegraph, London

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