Considering last weekend saw the biggest bank failure since the Global Financial Crisis it has been a surprisingly positive week in equity markets
With risk appetite swiftly recovering after the initial shock of the rescue of Credit Suisse by UBS in a deal brokered by the Swiss National Bank (SNB) and FINMA, the Swiss financial market regulator.
After a weekend where it became abundantly clear the Swiss authorities were urgently trying to complete a rescue deal before markets opened on Monday, the 167-year-old Swiss bank was taken over in a deal which valued Credit Suisse at just over $3 billion; quite a contrast to the $8 billion market cap at the close on Friday. Credit Suisse shares at the takeover price were down 99% on their peak in April 2007. As I mentioned last week, Credit Suisse is (was) amid a restructuring program aimed at restoring profitability, focusing on wealth management and retail banking and divesting the investment bank.
However, the impatient mood in markets driven by the troubles in US regional banks and the public announcement that (for regulatory reasons) the Saudi National Bank, the biggest shareholder in Credit Suisse, would not be increasing its stake accelerated the levels of client outflows. As recently as last Wednesday the Swiss National Bank had offered Credit Suisse a $50bn liquidity line but they were clearly very concerned over deposit flight, and this was clearly insufficient to restore confidence and stem client withdrawals. There was also chatter about institutional counterparties seeking to reduce their exposure to the bank. While Credit Suisse was still solvent, with a solid capital ratio, the Swiss authorities chose to euthanise the Bank before a full-scale crisis developed.
The structure of the deal proved controversial and caused further volatility in bond markets at the start of the week. To sweeten the deal for UBS, the SNB offered a $110 bn liquidity line and a loss guarantee which means the Swiss government will backstop CHF 9 billion of losses after UBS shoulders a potential CHF 5 billion loss as it restructures and integrates the remnants of Credit Suisse. The market fallout was around the treatment of Additional Tier One (AT1) bondholders – these are meant to rank senior to equities in the event of a failure, but the Swiss chose to wipe out $17 billion of AT1 bonds while equity holders received a few crumbs in the shape of UBS shares. While shareholders have seen the value of their shares fall dramatically, the expected approach was that shareholders would be wiped out before AT1 bondholders took any losses.
But the Swiss appear to have torn up the rulebook, indeed the law was tweaked on Sunday to allow this process to take place. As a result, Monday saw the AT1 bonds of other banks across Europe and further afield selling off sharply given the precedent set by the Swiss authorities. However, by 10am on Monday morning the European Banking Authority issued a statement reiterating that for banks outside Switzerland, bonds only take losses after contributors of Tier One equity, such as shareholders, have been wiped out. The Bank of England echoed the EBA, saying the UK bank resolution framework had a “clear statutory order” as demonstrated in the case of the UK part of Silicon Valley Bank. The statements brought eventual calm to a market which is around $275 billion. The issue would have been that without AT1 ranking senior to equities, further capital raises by banks using AT1 bonds would have been unviable, meaning they would have to switch to more expensive funding options, such as equity rights issues.
In addition to the rescue for Credit Suisse, a group of major central banks, including the Bank of England, Canada, Japan, European Central Bank, Swiss National Bank and US Federal Reserve (Fed) announced measures “to enhance the provision of liquidity” allowing banks to issue daily US dollar liquidity as “an important backstop to ease strains in global funding markets”. This facility will be in place at least until the end of next month and mirrors similar schemes put in place during Covid in March 2020 and during the Global Financial Crisis. US Treasury Secretary Janet Yellen noted that the US authorities were considering further policy measures to support US regional banks, whose share prices have remained volatile this week. Yellen said that “similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion”. The expectation is the US will move to increase the level of insurance for bank deposits to bolster depositor confidence. In addition, there is an expectation that the larger banks will co-ordinate efforts to inject liquidity or even capital into some of the regional banks.
The Fed raised interest rates by 25 basis points in their meeting that concluded on Wednesday with the ‘dot plot’ of committee members suggesting they anticipate rates to by 5.1% by the end of the year. A gap has once again opened between market expectations and the Fed on the duration that interest rates will stay at their peak level, with Fed Funds futures suggesting rates will be down to 4.22% by year end. The Fed stated that the US banking system is “sound and resilient” but noted that “recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring and inflation…the extent of these effects is uncertain”.
Acknowledging the recent bank turmoil, Fed Chair Jay Powell noted some Fed members considered a “pause” in the days leading up to the meeting. Powell noted though that the US labour market remains tight and a key focus for the Fed. Powell remains cautious against easing policy too soon and avoiding the “stop and go” policies of the 1970s when the Fed repeatedly halted the fight against inflation too soon. Powell said that “rate cuts are not our base case” but it appears the Fed has recognised that rate cuts cannot go much further as they try to balance their need to beat inflation with ensuring this does not cause too significant stresses within US financial system.
Yesterday saw the Bank of England increase interest rates for the 11th consecutive meeting, with rates increasing by 25 basis points to 4.25%, the highest level since October 2008. Governor Andrew Bailey delivered a more upbeat message on the economic outlook saying, “we were really a bit on a knife edge as to whether there would be a recession… but I’m a bit more optimistic now”. The Banks expects inflation to “fall sharply over the rest of the year” and sees the economy in reasonable shape, without a significant increase in unemployment expected. The UK CPI data released on Wednesday would have given the Bank of England some pause for thought ahead of their rate meeting yesterday. CPI for February was 10.4% year on year, up from 10.1% in January and well ahead of the 9.9% expected by the Bank of England. Core inflation, which excludes food and energy, jumped from 5.8% to 6.2%. UK inflation is looking very sticky, despite the optimism of the Bank of England.
The market maxim that the “Fed keeps hiking until something breaks” is now playing out. Every Fed hiking that leaves the yield curve inverted for an extended period, as we have seen in recent months, causes stress in the financial system. History is repeating itself once again with the troubles in US, and now European banks. While the policy response has been swift, and the big banks are in far better shape that in 2008, this does not mean that recent events won’t increase the likelihood of an economic recession as the availability of credit contracts further. Weaker banks – the US regional banks that have escaped the regulation of their larger peers for example – will need fresh capital or be taken over, while the policy response will be required to boost confidence with interest rates ultimately having to come down.
2008 was a lesson that these issues take time to play out and a few calmer days in financial markets does not mean we can draw a line under recent issues. Whether the Fed can keep rates elevated long enough to defeat inflation while avoiding further cracks in the financial system is now the big question. Market expectations of Fed policy have moved in extreme ways in the past fortnight. Since the inception of Fed funds futures 29 years ago, the only periods with similar volatility were in January 2001 at the start of a hiking cycle, after the 9/11 attacks, the GFC in 2008 and when Covid-19 arrived in March 2020. All those periods saw the Fed cutting rates in response to a crisis. But this time they still have a fight with inflation. Fed Chair Jay Powell has a tightrope to walk from here.
We remain cautious in our positioning but take some comfort from the fact that we have seen the first failure of a systemically important bank since 2008 and the rescue of Credit Suisse has been absorbed by financial markets without significant volatility. Credit Suisse was seen as something of an outlier among the major banks in terms of its recent issues and the lack of any signs of contagion across other systemically important banks this week is encouraging. All the same, it does feel like there are many unresolved issues right now, not least as the focus returns to US regional banks. Credit Suisse AT1 bondholders will no doubt be speaking to their lawyers in the coming weeks, but it was very important for the European and UK regulators to distance themselves from the actions of the Swiss in upending the hierarchy of capital in pushing through the Credit Suisse rescue. Last week I wrote that troubles in the financial system pose risks to credit availability and the events of this week make though risks even higher. We expect further policy measures to support the banks in the coming weeks but equally, we do expect to see some economic fallout as banks ease back on their appetite to take on risk.
