Finance: Planet on High Alert by Nicolas Bouzou

Without clarity, there is no solution to the problem. Therefore, it should be said that the banking crisis is serious. Failure would be a disaster. A few days later, we witnessed the second and third largest bankruptcies in the history of American banking (Silicon Valley Bank and Signature Bank), the American banking authorities had to guarantee all deposits of these two institutions, the Federal Reserve (the American central bank) had to develop an emergency loan plan for banks , the same Fed should revise its anti-inflation program, 11 banks intervened to save one of their own (Bank of the First Republic).

In Europe, the ECB has not yet changed its policy, but the Swiss Central Bank has provided a Credit Suisse loan of just over 50 billion euros. Admittedly, financial markets have a herding and self-fulfilling behavior. But psychology and facial expressions, if they amplify crises, are insufficient to recap what has just happened. The events of the past few days have fundamental and identifiable causes. The American (and to a lesser extent European) banking system is shaken by the exit from the world of interest rates at 0%, even as technological innovation blurs economic benchmarks and the Internet accelerates banking crises.

Let’s look at these three points (rate 0, technological innovation, internet banking) and analyze their interaction in order to fully understand what is currently happening in the bowels of the banking and financial system.

The strategy of private equity players: “scatter wide”

With the Covid pandemic, monetary policy has shifted to a so-called “fiscal dominance” regime. When economists use this expression, they mean that monetary policy has lost its de facto independence, guided by the imperatives of fiscal policy and the absolute will to avoid the risk of state insolvency. The pandemic has forced almost all developed countries to implement exceptionally large spending programs to protect businesses, compensate for part-time work, and increase healthcare spending. This increase in spending was mainly funded by public debt, especially in Europe. Even if the ECB does not have the right to lend to states directly, it can help them indirectly, for example by buying sovereign bonds from banks or insurance companies, to avoid any risk of a public default. It also affects the ability of states to increase debt by setting the level of short-term interest rates. This setting of interest rates at zero or even negative levels affects the entire yield curve. Thus, when markets are almost certain that central banks will leave their rates at 0, long-term rates (five or ten years) spontaneously weaken.

Episodes of financial dominance have preceded the pandemic, such as in 2012, when Greece’s public finances were near desperate and Italy’s public finances were deteriorating. But it was during the Covid crisis that zero or even negative interest rates allowed states, as well as the financial sector, to take advantage of exceptional funding conditions. The onset of inflation, partly due to this very expansionary monetary policy, radically changed the environment in which the Silicon Valley Bank (SVB) found itself. The clients of this California bank were startups from Silicon Valley, whose money he kept. With the increase in short-term interest rates implemented by the Fed to combat inflation, SVB was forced to increase its deposit fees. His holdings consisted mostly of government bonds, which dwindled in value as interest rates rose. Indeed, a bond bought two years ago with a 0% yield will fall in price when it becomes possible to buy a bond of exactly the same type, but with an interest rate of 3.5%. SVB has experienced a drop in the value of its assets despite having to reward deposits reflected in its liabilities and fulfill withdrawal requests (bank run).

The banking crisis is part of the context of the third industrial revolution, i.e. the convergence of digital technologies, artificial intelligence, robotics and biotechnology. As with any cycle of Schumpeter’s creative destruction, the changes brought about by innovation are not only technological but also economic. Business models are disrupting: music, media, film, distribution, and even the automotive industry are shaken by these industrial revolutions. During these periods, the valuation of companies becomes difficult, the factors of success or failure are more difficult to determine. Hence the strategy of many private equity players to swim on the water, hoping that one successful investment will cover the loss of nine unsuccessful investments.

The ‘Big Cleanup’ is as painful as it needs to be

This strategy becomes more difficult to implement when the cost of financing for private equity participants increases with rising interest rates. Capital sponsors, who have fewer resources, become more selective. And the startup ecosystem is going through a “big purge” as painful as it needs to be. We are here ! It was against this tense backdrop that Silicon Valley investors advised their companies to withdraw their deposits from SVB and place them in a safer bank, which triggered the crisis. SVB was unable to recover enough money to cover the withdrawal by selling the collapsed bonds. This context of creative destruction is only a secondary difficulty for the financial system compared to rising interest rates. But it adds a dose of uncertainty and anxiety, which was less during the 2008 crisis.

The third industrial revolution also directly affects the banking system. We know that in finance, speed is the enemy of good. That’s why there are “off switches” in the financial markets: when the value of a security suddenly drops, its price is temporarily suspended so that everyone can recover. Smartphones allow you to conduct banking transactions with a swipe. In 2008, bank runs were caused by queues in front of ATMs. In 2023, banking transactions are completed from a smartphone in seconds. What has been striking since the beginning of this crisis is the speed of the chain of events. Banking applications bear their share of the responsibility not for the start of the crisis, but for its severity.

This speed hit the American banking and financial authorities (Fed, Treasury, supervisors), who reacted very quickly by insuring all the deposits of failed banks and providing more liquidity to the banking system. Shareholders should lose their share, but not investors. The failure to bail out Lehman Brothers on September 15, 2008, and the slowness of the national authorities to bail out other banks, is still on everyone’s mind. Fortunately, a large number of current leaders survived the horrors of 2008, when, in the words of Nicolas Sarkozy, then head of state, “the world economy was bled dry.”

The systemic risk of failing network banks should be avoided precisely because 2008 is still on everyone’s mind and because the authorities are doing the right thing. On the other hand, it is possible that we will experience a global contraction in the supply of credit (which has already begun in some sectors such as real estate). Banks will have to increase the value of their capital, remain highly liquid, reduce their risks: there will no doubt be less credit in the coming months or even in the coming years.

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