Fallout from sale of Credit Suisse prompts Canada’s banking regulator to soothe bond holders
OSFI says debt holders are entitled to a better outcome than common shareholders
The collapse of SVB Financial Group’s Silicon Valley Bank on March 10, and then the forced sale of failing Credit Suisse Group AG about a week later, has put global financial markets in their worst state of panic since 2008, when cascading bank failures in the United States and Europe caused credit markets to seize, triggering what came to be known as the Great Recession.
Things aren’t that bad this time. But they aren’t good either. Here’s what you need to know:
Here’s what’s happening now
The Bank of Canada joined five other central banks — the United States Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the Swiss National Bank — in a co-ordinated effort to calm financial markets on March 19, hours before trading opened in Australia, New Zealand and Asia.
Central bankers said they would tweak an existing arrangement that will allow them to push more U.S. dollars into their financial systems on a daily basis, if needed. The announcement followed confirmation earlier in the day that Swiss authorities had successfully brokered a deal in which UBS Group AG, Switzerland’s largest bank, will purchase Credit Suisse for the equivalent of about US$3.3 billion.
Shares of Credit Suisse, Switzerland’s second largest bank, plunged to record lows last week after its biggest shareholder said in the aftermath of the Silicon Valley Bank (SVB) collapse that it would not raise its 10 per cent stake. Trading in the shares was halted a number of times as volumes soared and the stock plummeted.
The sight of a significant American bank (SVB) and one of the world’s largest financial institutions (167-year-old Credit Suisse) rattled confidence in financial systems around the world as investors wondered who could be next. By sending the message that there will be no reason to worry about running out of dollars, the world’s de facto currency, the world’s central banks are sending the message that no one need worry about getting caught short.
Markets steadied, but there was still unease and upset. Holders of US$17 billion worth of a special type of debt that is supposed to convert to equity when banks get in trouble were instead wiped out when UBS took over Credit Suisse. That shook confidence in the market for “Tier 1” bonds, and appeared to prompt Canada’s banking regulator to issue a statement on how it would rank debt holders in similar circumstances.
“Canada’s capital regime preserves creditor hierarchy which helps maintain financial stability,” the Office of the Superintendent of Financial Institutions said on March 20. If conditions triggered the conversion of such debt into shares, it would result in “significant dilution to existing common shareholders,” the regulator said, adding that debt holders “are entitled to a more favourable economic outcome than existing common shareholders who would be the first to suffer losses.”
Here is what has happened
- U.S. President Joe Biden addressed the nation on March 13, stating he will do “whatever is needed” to protect bank deposits after three mid-sized American banks failed in a matter of days.
- The U.S. Federal Reserve and the Treasury Department scrambled the weekend before to erect financial backstops that they said would protect depositors of California-based Silicon Valley Bank and New York-based Signature Bank, which were closed by state regulators on March 10 and March 12, respectively.
- In the United Kingdom, authorities seized the British operations of SVB over the weekend and sold them to HSBC Holdings PLC for the equivalent of US$1.21.
- Canada’s banking regulator took over the Canadian operations of SVB on March 13, the first such action since OSFI wound up the Canadian operations of Germany’s Maple Bank GmbH in 2016.
- Banks borrowed a record US$164.8 billion in the week ended March 15, compared with US$4.58 billion the previous week, from two lending programs the Federal Reserve runs to ensure financial institutions have access to cash to meet short-term obligations.
- The largest banks in the U.S., led by JPMorgan Chase & Co., agreed to deposit US$30 billion at First Republic Bank, a regional lender whose shares had plunged as much as about 40 per cent in the aftermath of SVB’s collapse.
California’s banking regulator closed SVB Financial Group’s Silicon Valley Bank (SVB) on March 10 and asked federal authorities to sell the assets amid a run on the financial institution’s deposits. It was the second-biggest bank failure in U.S. history and stirred memories of the events that preceded the Great Recession in 2008 and 2009.
SVB wasn’t a typical bank. It was formed in the early 1980s in Santa Clara and quickly became the bank of choice for the region’s burgeoning technology industry, boasting that it banked “nearly half” of U.S. startups that had received funding from venture capitalists, and that 44 per cent of venture-backed technology and health-care companies that went public in 2022 were SVB clients.
Tech was a good place to be for much of the past couple of decades. But it also meant that SVB had a lot of eggs in one basket. As inflation and interest rates soared last year, investors grew less willing to get behind companies that were putting growth ahead of profits, causing a chill among a set of companies that hadn’t had to work very hard to raise money during an extended period of ultra-low interest rates. That meant SVB didn’t have as much money coming in.
Higher interest rates squeezed SVB from the other side of its balance sheet, too. Its clients were so flush with cash that SVB couldn’t deploy all their deposits by way of new loans, which is typically the way a bank makes money. Instead, it used its excess deposits to buy bonds, which is also standard procedure for financial institutions. But those bonds steadily dropped in value as interest rates rose because there was less demand for older securities that came with lower yields.
Eventually, depositors grew nervous about the health of SVB’s balance sheet and started a run on its assets last week. That’s when regulators shut it down.
In the aftermath, some commentators dismissed comparisons to the 2008-09 financial crisis, given SVB’s troubles are related to mistakes by management and its overexposure to a single industry. However, regulators in New York state on March 12 closed Signature Bank amid signs of a run on its deposits. It was the third U.S. regional bank to collapse in five days, following SVB and Silvergate Capital Corp.
Both Signature and Silvergate were exposed to FTX, the cryptocurrency exchange started by Sam Bankman-Fried, who faces criminal charges over the implosion of his company.
Why the fuss over a few mid-tier banks?
There’s a general uneasiness in financial markets over whether the global economy can handle the sharp increase in interest rates orchestrated by the Fed and other central banks over the past year. Labour markets in the U.S., Canada and elsewhere have held up surprisingly well so far, but inflation also remains high, and history suggests the only antidote for runaway inflation is a painful economic downturn.
Fed chair Jerome Powell shook traders on March 7 when he said better-than-expected economic data meant he would have to keep raising interest rates to offset inflationary pressure. Previously, he had indicated that he thought the worst was over. The zigzag caused some investors to lose confidence in the central banks’ ability to snuff out inflation without causing a recession. In other words, plenty of people were waiting for another shoe to drop and are now betting SVB was it.
Even if the negative takes on SVB are wrong, there’s no denying the bank’s troubles herald a difficult period for lenders. Bigger banks with more diverse sources of revenue face little risk of collapsing, even if there’s a recession. But many will be caught in the same jam that squeezed SVB: less money coming in, while assets on their balance sheets deteriorate in value. Most big banks should be profitable enough to survive, but those profits will shrink for a period of time. Smaller lenders that are overly dependent on single industries or businesses might not be.
Washington was unwilling to take its chances on the optimistic scenario. In a series of extraordinary actions that brought back back memories of the 2008-09 financial crisis, the Fed and the Biden administration extended rules that were put in place to govern too-big-to-fail banks to cover smaller SVB and Signature, declaring that depositors would be “fully” protected.
Why the fuss over Credit Suisse?
The 2008 financial crisis triggered an historic recession because the calamity involved so many large global banks. Supervisors vowed to tighten the leash on “systemically important” financial institutions by subjecting such banks and insurers to extra scrutiny, including an obligation to hold extra capital as a form of mandatory self-insurance. The Financial Stability Board‘s list of global systemically important banks now numbers 30 — and it includes Credit Suisse.
Like SVB, Credit Suisse’s issues were related to mismanagement; there’s no evidence that its demise is indicative of a systemic problem. However, the bank was too big and too spread out around the world to allow its problems to persist for too long. If the death of a mid-sized U.S. bank could shatter confidence in the financial system, imagine what would happen if a major lender toppled. That’s why Swiss authorities used the weekend to effectively force Credit Suisse to sell itself to its longtime rival. A lesson of 2008 and 2009 is that allowing these situations to drag out only makes things worse.
Switzerland would probably rather have two large banks competing with each other than one mega-bank. But that will be a problem for another day.
What exactly did the central banks do?
The original mandate of central banks was to be “lender of last resort.” The way they do that is by making cash available to private lenders under conditions that would be unattractive in normal times — but very attractive when there are no other options.
It works well when the troubled lender needs local currency, because central banks can create as much as they need. It works less well when the troubled lender needs U.S. dollars, which is now very often the case because so much of the world’s goods and services are priced in America’s currency. Central banks such as the ECB and the Bank of England have plenty of dollars in reserve, but they don’t have an unlimited supply. When the 2008 crisis was most acute, there weren’t enough dollars to keep Wall Street and the City of London pumping cash through the global financial system. Credit creation froze.
Central banks, led by the Federal Reserve, figured out a fix: they set up “swap arrangements” (also called “swap lines”) that would allow them to draw on each other’s reserves of U.S. dollars (and other currencies) when they started to run low. In effect, the Fed became the lender of last resort for the world.
When the Great Recession passed, the central banks decided to leave some of these programs in place in case they were ever needed again. Fearing how markets might interpret the near failure of a big international financial institution, the Bank of Canada and its counterparts decided over the weekend to hold auctions for dollars daily starting March 20, rather than weekly.
These “daily operations” will “continue at least through the end of April,” the central banks said in a statement. The Financial Times reported that the Bank of Japan and the Bank of England received no bids, while the European Central Bank allotted just US$5 million to a single bidder.
What about Canada?
Canada’s federal banking regulator took control of SVB’s Canadian operations on March 13, ending some of the unease over what might become of deposits that local technology companies had left with the Toronto-based branch.
Peter Routledge, the superintendent of financial institutions, stressed that no individual Canadians banked with SVB, so any fallout will be limited to technology companies and venture-capital funds. According to filings with OSFI, SVB had a loan book totalling $435 million in Canada and reported $864 million in total assets here as of the end of 2022. The country’s biggest banks can easily fill the gap.
Still, Canada’s tech entrepreneurs are uneasy. They have long complained that the stinginess of the country’s risk-averse banks was a barrier to Canada taking full advantage of the historic shift to a digital economy and greener sources of energy. Many welcomed SVB’s arrival in 2019 as both a new source of lending and a competitive jolt to Canadian lenders.
“While there is an immediate impact on Canadian companies that deal with SVB, the longer-term impact is the loss of a globally competitive and technology-company focused banking service,” Jim Hinton, a patent lawyer who works with many technology companies, said in an email. “SVB forced Canadian banks to be more competitive and savvier when providing services and understanding the needs of technology companies.”
It might be the wrong moment to determine whether Canada’s big banks will provide the kind of support that tech startups enjoyed from SVB going forward. Their stocks were all trading lower as of March 14 compared with five days earlier, dragging the S&P/TSX composite index down with them. Things haven’t improved much since. Royal Bank of Canada’s shares ended trading on March 17 about eight per lower than a month earlier.
What does this mean for interest rates?
Ahead of the SVB failure, investors were convinced that the Fed would keep raising interest rates aggressively. January inflation came in hotter than most were expecting, and Powell told lawmakers on March 7 that the “ultimate level of interest rates” will likely need to be “higher than previously anticipated.”
Some analysts reckoned the Bank of Canada would have to follow because a wider rate differential with the Fed would weaken the Canadian dollar, which would make imported goods more expensive.
Many of those bets are now off. The Fed has three jobs: price stability, doing what it can to boost employment and maintaining calm in financial markets. It’s difficult to do all three of those things at once. In fact, some economists say it’s impossible.
However, those economists don’t have a mandate from Congress to try anyway. New data on March 14 showed inflation stayed hotter than central bankers’ would like in February. Given the Fed’s responsibilities to maintain both price and financial stability, it probably will attempt to strike a balance and raise interest rates at a slower pace.
“Absent the recent turmoil in the banking sector, this data would likely have pushed the Fed to re-accelerate their pace of rate hikes,” economists at Deutsche Bank AG said in a note. “However, given the volatility, real-time risk management and the experience last year around the beginning of the Russia-Ukraine war argue for a more moderate increment or even pausing.”
OSFI seizes Silicon Valley Bank’s Canadian assets
SVB collapse that shook the world reveals cracks in system
If a Canadian bank fails, how much do you get back?
It’s worth noting that the financial turmoil didn’t stop the European Central Bank from increasing interest rates a half point on March 16. ECB president Christine Lagarde insisted there was no “trade-off” between inflation and financial stability, as the central bank had plenty of tools at its disposal to achieve the latter without easing up on interest rates.
• Email: [email protected] | Twitter: carmichaelkevin
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