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Australia And The US Bank Crisis

Feature Stories | Mar 23 2023

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

Investors have voted with their feet, but how bad is the US banking crisis and how may this affect Australia?

-The S&L crisis all over again (?)
-Discrepancy in accounting
-Recession risk
-Australia’s banks

By Greg Peel

"You're thinking of this place all wrong, as if I had the money back in a safe. The money's not here. Your money's in Joe's house, right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others,"

-George Bailey (Jimmy Stewart) in It’s a Wonderful Life, 1947.

Savings Versus Loans

In 1973, then US president Richard Nixon, in order to recover the cost of the Vietnam War, decoupled the US dollar from the gold standard that had been in force since the end of the Second World War. The result was, aided by an Arab oil shock, US inflation jumped from 4.7% in 1973 to 12.3% by the end of 1974.

The Fed hiked its funds rate in response, to 16% in March 1975, but this only made the resultant 1973-75 recession worse, so it cut again in April, all the way to 5.25%. It was Fed chair Paul Volker who finally ended the vicious cycle in 1979 by deciding inflation simply had to be tamed, recession or not.

US inflation reached a peak in 1980 of 14.6%. In January 1980 the Fed funds rate was 14%. By December 1980 it had been hiked to its historical peak, being 19-20%. It worked. A recession ensued, allowing the Fed to reduce its funds rate very gradually to more manageable levels by the 1990s.

Any of this sound familiar?

The US Savings & Loan industry grew out of the Great Depression, to take deposits and lend on mortgages at a smaller, regional level than the big banks, and to not offer other services provided by the big banks (such as cheque accounts). In Australia we called them “building societies”.

Prior to 1980, S&Ls had issued long-term loans at fixed interest rates that were lower than the new interest rate at which they could borrow. When interest rates at which they could borrow increased, the S&Ls could not attract adequate capital from deposits and savings accounts of members.

Attempts to attract more deposits by offering higher interest rates led to liabilities that could not be covered by the lower interest rates at which they had loaned money. The end result was that about one third of S&Ls became insolvent.

Between 1986 and 1995 around a third of US S&Ls – around 1000 out of around 3000 – failed. Ultimately, taxpayers were called upon to provide a bailout.

S&Ls do still exist in the US, but these days are better known simply as “savings banks”. In between these and the big money-centre banks such as a JPMorgan Chase or Bank of America sit the commercial regional banks. Regional banks typically provide the same services as a big national bank, but within a specific region, and are much smaller.

The government-owned Federal Deposit Insurance Corporation insures deposits up to the value of US$250,000 in over 4,800 US banks.

Déjà vu?

Silicon Valley Bank, based in San Francisco, focused heavily on US technology start-ups. During covid, SVB saw a surge in deposits as tech companies profited from providing entertainment and delivery services to people confined to their homes. Those deposits were invested in longer term US bonds.

When the covid boom eased for SVB’s depositors, they started to withdraw, leading the bank to sell its bonds to cover the withdrawals. The problem was the Fed had hiked its funds rate from a covid-emergency 0-0.25% up to March 2022 to 4.50-4.75% in March 2023. A rise in bond yield implies a fall in bond price, hence SVB had to sell its bonds at a loss.

The bank then announced a planned capital raising. The effect was the opposite – a run on the bank as depositors quickly withdrew their funds. Two days later, the FDIC shut the bank’s doors.

Fearing similar problems across the US banking sector, depositors into other regional banks also began withdrawing and the share prices of those banks plummeted. To head off a meltdown, the FDIC, Fed and US Treasury agreed together to insure all regional bank deposits. Not a handout, but a backstop, providing depositors with no reason to panic.

It did not help that shortly after SVB went under, Credit Suisse revealed discrepancies in its accounting for the 2021-22 financial years. The timing was very unfortunate. While unrelated to the US regional bank issue, Credit Suisse’s revelations only fuelled fears of a global financial crisis, similar to one we saw not so long ago.

In the wake of SVB, another San Francisco-based bank, First Republic, was the next to see its share price plummet, assuming guilt by association. Eleven of the largest US banks subsequently stepped in to deposit a collective US$30bn to head off a panic. The share price continued to fall until this week when US Treasury Secretary Janet Yellen assured the SVB backstop could be applied to any regional bank.

But this is not the GFC all over again. Before 2007 the major US banks, and particularly investment banks, were undercapitalised and way over-leveraged. And particularly over-leveraged to smoke & mirrors type assets such as Collateralised Debt Obligations (CDOs) which suddenly one day had no value.

To head off disaster in that instance, the Fed encouraged the biggest banks to “buy out” the smaller, for as good as nothing, leading to acquisitions such as Merrill Lynch by Bank of America and Bear Stearns by JPMorgan.

Lehman Bros was one bridge too far – the resultant financial collapse forcing a massive taxpayer-funded bailout.

Plus a near-zero Fed funds rate and quantitative easing for years to come.

The GFC led to the creation of the Domestically Systemically Important Bank (D-SIB), colloquially known as banks that are “too big to fail” in their own countries. Far stricter global regulations were placed on capital requirements and leverage to risk assets. Australia has four – you might be able to guess – and the regulator, APRA, has since gone further and required even greater capital levels.

Leading into SVB, Australia’s majors comfortably exceeded their capital requirements.

So no, the recent banking crisis is not another GFC in the making. It does, however, resonate with the earlier S&L crisis.

A Bone of Contention

When one purchases a bond from the US government, rated AA+ by S&P, or from the Australian government, rated AAA, one can safely assume all interest payments will be made and face value returned at maturity. That’s why the rate on a ten-year government bond is known as the “risk free rate”.

But those bonds can be traded before maturity on the secondary market, and the value of those bonds is determined by the prevailing interest rate rather than the rate at the time of purchase. If rates go up in the interim, the value (price) of existing bonds goes down. If you “mark-to-market” the value of your investments, you would show a loss on your bonds if rates have gone up.

A paper loss. If you hold to maturity, it’s irrelevant. But if you sell before maturity, that loss will be realised.

The focus stemming from the SVB collapse has been on “uninsured” deposits – deposits in excess of US$250,000 which were not guaranteed by the government, meaning anything over that you can lose altogether if your bank goes under.

SVB was forced to sell some of its bonds ahead of maturity to cover its uninsured deposits, and in so doing crystallised the loss on those bonds. In order to make up the difference it announced a capital raising. It might as well have said “shoot me now”.

For other banks there is a risk that were their bond holdings marked-to-market to a level below their level of uninsured deposits, they would be insolvent, but only on paper.

An academic study* published on March 13 revealed marked-to-market assets (eg Treasuries, mortgage-back securities) have declined in value by an average -10% across all US banks, with the worst 20% seeing -20% declines. Of that number, 10% of banks have larger unrecognised losses than SVB, and 10% have a lower capitalisation than SVB.

The problem was only 1% had a higher proportion of uninsured deposits. SVB was not your average mom & pop lender, rather a specialist lender to Silicon Valley tech start-ups, which held corporate deposits in the millions. It doesn’t matter how large or small your deposit base is, it only matters how many individual deposits exceed US$250,000. The biggest money centre banks hold the largest level of deposits but the majority of smaller, average-Joe deposits.

When SVB announced a capital raise the word went out across the Valley – get your money out now. The problem with bank runs is they are driven by psychology and fear and are thus self-destructive, whether warranted or not. SVB set off a nationwide run on regional banks and a collapse in bank share prices that forced the government (FDIC, Fed, Treasury) to step in.

The aforementioned academic paper estimates that even if only half of uninsured depositors decide to withdraw, almost 190 US banks are at a potential risk of impairment to insured depositors, with potentially $US300bn of insured deposits at risk. If uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk. Overall, these calculations suggest that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs.

But what if you don’t have to sell your bonds?

“The primary measure driving regional bank stocks,” note analysts at Citi, is the inclusion of “unrealised securities losses in regional bank capital, and many banks look undercapitalised. We disagree. Banks use securities portfolios to help manage residual interest rate risk and unrealised losses are not related to credit risk, but rather interest rate risk which approaches zero over time”.

Credit risk is the risk of your loans to borrowers not being serviced and repaid; interest rate risk approaches zero over time as the value of a loan will reach face value at maturity at which point there is no further risk.

“Banks have adequate liquidity,” Citi suggests, “but the banking system is reliant on confidence and cannot withstand deposit runs. When the market uses ‘new’ accounting to assess risk and stocks sell off, this can impact depositor psychology and risks becoming self-fulfilling, even though the initial proposition was fundamentally incorrect”.

In other words, if you have enough to cover your deposits, it matters not what interim value is placed on your coverage.

Unless it matures.

The Road to Recession

A ten-year bond is only a ten-year bond the day you buy it. Next year it’s a nine-year bond. Banks will constantly be buying bonds across duration periods and replacing them when they mature. Deposits are open-ended. Given the rapid rise in US interest rates over the last year, banks (and all businesses with debt) will need to refinance maturing loans at much higher rates (cost).

See: Australia’s upcoming fixed rate “cliff”. Mortgages are not immune.

This is a primary reason why central bank interest rate hikes impact with a lag. Not everyone has to refinance a loan the day of a rate hike, but at some point down the track they will. It’s taken a year for SVB’s problems to become apparent.

Morgan Stanley wrote last week:

The potential broader implications of last week’s events include: higher cost of funding, higher cost of capital, and eventually, more consolidation, in our view. Tighter lending standards will slow growth and hiring. Weekly lending and labour market data will be the first to show signs of stress, but we're not likely to see the full effects for several weeks.”

More lag.

As as a bank’s cost rises with interest rates, its deposit rates will need to be lifted to attract the funds to cover the loans, weighing on bank margins. Banks will need to be more careful about lending money, and thus “tighter lending conditions” will lead to businesses no longer being able to afford to borrow, or to refinance maturing loans.

Businesses will close, jobs will be lost, mortgage payments will be unable to be met.

When the Fed started hiking rates aggressively, including four consecutive 75 pointers last year, Wall Street warned that such a rapid catch-up after getting inflation so wrong in 2021 will lead to the Fed going too far, and “something will break”.

Well, something broke.

The bad news is a US recession seems to be more a case now of “when” and not “if”.

The good news is the fallout from SVB – tighter lending standards, higher funding costs, job losses – is highly disinflationary.

Sticking to the Script

As was widely expected by the market, the Fed has raised by another 25 points this month to 4.75-5.00%. To not have raised would be to have signalled to the market something was indeed wrong with the banking system.

The market also assumed the Fed would tone down its hawkishness in the wake of SVB and signal a pause ahead. It didn’t. With no change to a Fed peak rate forecast of 5.00-5.25%, the market is assuming yet another 25 points at the next meeting in May.

The Fed did acknowledge the impact of tighter credit conditions is indeed disinflationary, and will do some of the Fed’s work for it, but inflation is the bigger risk. Despite the first signs of lagged fallout from a year’s worth of rate rises, the Fed will keep going.

And don’t think there’s any chance of a rate cut this year.

The US bond market is pricing in several rate cuts in the second half of this year, as recession bites.

Meanwhile, after assuring the market the Treasury would step in with deposit backstops if other banks found themselves in trouble in the wake of SVB, Secretary Janet Yellen subsequently dismissed a pre-emptive, blanket guarantee of all deposits as this would require “extraordinary circumstances” and an act of Congress.


Silicon Valley Bank’s tentacles stretched across the Pacific, with a handful of recognisable local tech stocks and others such as venture capitalists having loans from/deposits with the now defunct bank. The deposits are guaranteed by the US government, and the direct impact is negligible.

The indirect impact is not so negligible, as evidenced by the sharp slide in the ASX200 post the SVB collapse (and Credit Suisse rescue), led by the financials sector. Australia’s banks might be well capitalised, and the local tech start-up industry tiny compared to the US, but fear is fear and there’s not much you can do about it.

Australia’s banks are facing the same problem – SVB or no SVB – that their cost of funding has sharply increased and they will need to refinance maturing debt, and raise deposit rates, in the wake of sharp rate hikes both here and in the US.

Australian banks issue a lot of debt in the US, typically at five-year maturities.

Australian banks have substantially improved their funding and liquidity positions in the last 15 years, notes Macquarie. But at times of uncertainty and volatility, bank boards and managements are likely to become even more cautious. The broker expects a heightened focus on shoring up stable deposits, funding and liquidity.

Prior to the current dislocation (ie SVB, CS), banks faced a significant refinancing task of some $70-110bn each over the next three years. While to date they have made decent progress, raising around 50-70% of their FY23 maturities, Macquarie expects the focus on funding and liquidity to put pressure on bank margins.

The broker continues to see risk to bank margins and earnings in FY24 as consensus expectations do not appear to be fully reflecting higher funding costs and deposit competition. Macquarie sees Australian banks as “defensive but expensive” in the global context and remains Underweight the sector.

Then there’s the New Zealand factor.

APRA has proposed (in December 2021) new loss-absorbing capacity (LAC) requirements for D-SIBs (big four) intended to strengthen crisis-preparedness across banks, insurers, and superannuation trustees, due to come into force in 2024.

Meanwhile, New Zealand is planning some of the toughest bank capital standards worldwide to ensure lenders can weather a downturn.

The nation's four largest lenders will have to hold capital equal to at least 18% of risk-weighted assets by the end of a seven-year period that starts in July 2022. The smaller banks will need a minimum capital of 16%, which is double that of European lenders and significantly higher than in Australia. The current minimum regulatory capital required for all New Zealand banks is 10.5%.

The four largest lenders in New Zealand are the Commonwealth Bank of Australia ((CBA)), National Australia Bank ((NAB)), ANZ Bank ((ANZ)) and Westpac ((WBC)). One has proportionately more exposure than the other three (clue’s in the name).

Macquarie notes the banks need to issue some $1-2.5bn of qualifying Additional Tier One capital in New Zealand. If that market is inaccessible, banks may need capital injections to meet their NZ targets.

Additional Tier One (AT1) capital is not additional Tier One capital, but rather a different class of capital between Tier One and Tier Two.

Tier One capital is common equity (CET1) plus any retained earnings (but not provisions). Tier Two capital includes, among other things, provisions, eg for bad debts, and hybrid debt instruments that convert to common equity at some point under given criteria. They are debt until they become equity, but can become equity, so they’re counted as capital with a risk discount.

Typically a hybrid will convert to equity when a share price reaches a certain level to the upside.

Additional Tier One capital is similar, but opposite.

AT1 securities are a form of “contingent-convertible” bonds created after the GFC to prevent the need for government-funded bail-outs of precarious banks. “Cocos”, as they are known, are a hybrid of bank equity (the money invested by shareholders, which absorbs any losses in the first instance) and debt (which must be repaid unless a bank runs out of equity).

In good times, they act like relatively high-yield bonds. When things go sour, and trigger points are reached — such as a bank’s capital falling below certain levels relative to assets — the bonds convert to equity, cutting the bank’s debt and absorbing losses.

AT1 spreads have widened following recent market instability, Macquarie notes, as debt investors re-evaluate potential risks associated with these securities. Despite some structural differences, the broker expects the cost of AT1 and Tier 2 capital to rise, leading to further margin erosion.

Furthermore, Australian banks are relying on their ability to issue AT1 instruments in New Zealand (which at this point remains largely untested) to meet the higher NZ capital requirements.

Bank problems offshore have stemmed from deposit outflow issues, and regulators globally have stepped in to protect depositors. Given the strong financial positions of Australian banks, Macquarie sees the likelihood of material deposit outflows for the majors as very low. Furthermore, the broker estimates around 40-50% of majors’ deposits are protected by the Financial Claims Scheme.

The Financial Claims Scheme insures Australian bank deposits up to $250,000, just as the US FDIC insures up to US$250,000.

While Macquarie sees our banks as defensive, the broker expects more competition for stable deposits given their importance in the funding mix, and rising wholesale funding costs.

All of which leads to lower margins, and earnings.

*Monetary Tightening and U.S. Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?, Erica Jiang, Gregor Matvos, Tomasz Piskorski, and Amit Seru, March 13, 2023

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