The stability of the global banking industry has come under scrutiny as several high-profile banks have faced financial challenges over the past few weeks. The financial sector as a whole is facing significant challenges that few paid proper attention to until the failure of Silicon Valley Bank (SIVB, Financial) and the collapse of Credit Suisse (CS, Financial).
In this article, we explore the vital issues related to banking failures and economic risk, the comparisons between the ongoing bank crisis and the 2008 Financial Crisis and the relevance of Warren Buffett (Trades, Portfolio)'s timeless lessons.
The failure of small banks and the risk to the overall economy
The banking industry has again been scrutinized as small and mid-sized banks struggle to stay afloat. The failure of Silicon Valley Bank was followed by the failure of Signature Bank (SBNY, Financial), and First Republic Bank (FRC, Financial) is still struggling despite a Wall Street bailout, which has raised concerns about the financial sector's stability. The collapse of Silicon Valley Bank has been attributed to the bank's inability to make up for the Treasury bonds it had to sell at a loss as embattled tech startups drew down their deposits.
Source: Allianz
This recent banking crisis has raised comparisons to the 2008 Financial Crisis, with banks struggling to turn investments into liquid assets. The regulations imposed on banks after the Financial Crisis to prevent similar crises in the future have not been sufficient to protect smaller banks from failure. Deregulation in the 1970s and 1980s led to financial innovation and risky investments that created the 2008 Financial Crisis, and some fear that history may repeat itself after the U.S. rolled back Financial Crisis regulations for smaller banks a few years back.
However, despite the risk to the financial stability of the system, the U.S. economy has been performing well, with consumer spending remaining resilient. Moreover, U.S. President Joe Biden has reassured the public that their deposits are safe, and regulators have promised to cover the losses of depositors, even overriding the usual deposit insurance cap.
Consequently, the Federal Reserve has provided emergency funding to banks seeking to raise cash and pay off depositors. It aims to address the root cause of the banks' collapse: low prices on bonds that the banks had to sell to pay depositors.
Even so, the markets are experiencing uncertainty and volatility due to concerns about inflation and the banking sector's health. As a result, bank credit default swaps have widened, reflecting a poorer outlook for the banking sector. This has led to a partial flight to safe-haven assets and a bullish steepening of yield curves.
Overall, the failure of Silicon Valley Bank has once again brought to light the risks and challenges faced by loose regulations on the banking sector. While the U.S. economy remains resilient, there is a need for comprehensive depositor protection to shore up confidence in the financial system so that there are not more deposit runs. As long as people keep their money in the banks, they will not have to sell Treasuries at a loss, but this is only a temporary solution, and an unreliable one at that. Policymakers need to take steps to prevent the failure of other banks and avoid a full-blown contagion.
The fall of a titan
After a long period of financial losses, executive turnover and market crisis, Credit Suisse, Switzerland's second-largest bank, has been bought by its larger long-time rival, UBS Group (UBS, Financial), for around $3 billion. Why would such a big bank and cornerstone of the global financial market need to be bought? Because it would have collapsed otherwise. The "too big to fail" bank has gotten a rescue, but it still shook markets because these big global banks aren't supposed to need a rescue.
Unlike Silicon Valley Bank, which primarily serves U.S. venture capitalists and tech startups, Credit Suisse manages the money of billionaires and sovereign wealth funds, making it a systemically important bank. Credit Suisse's problems became urgent after the collapse of Silicon Valley Bank, which spurred questions about the industry's exposed weak link. Switzerland's government had to override competition law and shareholder rights to secure the UBS purchase.
One of the bank's problems was that it suffered a $5 billion loss due to the collapse of Archegos Capital Management and the bankruptcy of Greensill Capital. More recently, the bank faced extreme customer withdrawals, causing a 40% drop in deposits and a 30% drop in assets. Saudi National Bank's announcement that it wouldn't be adding to its 9.9% ownership due to regulatory rules sparked concerns about contagion. Credit Suisse's immediate sale to UBS raises questions about whether it's the first or last domino to fall.
It's not just Silicon Valley Bank and the other already-fallen; regional banks with risky practices are now facing worries as well, with potential suitors waiting to pounce on their weakened positions. Despite government bailouts, some banks are still struggling, and the threat of contagion is causing concern for global authorities.
Is the current crisis similar to 2008?
Overall, the recent banking crisis, triggered by flawed risk management practices, differs significantly from the 2008 financial meltdown. While Dodd-Frank has been weakened for smaller banks, most banks are much more well-capitalized now, and the collaterals they hold are fundamentally sound. Additionally, the crisis of 2008 was a credit crisis, while today's crisis is a balance sheet crisis (thank you, extreme easy-money policies).
Frankly, the failure of Silicon Valley Bank was an outlier due to its vulnerability; there aren't many banks as vulnerable as it was. The same could be said for Credit Suisse. As a result, I believe the banking industry is better off today, with improved capital, liquidity and stress tests.
Source: FDIC
Buffett's lessons and opportunities for berkshire
Warren Buffett (Trades, Portfolio)'s lessons learned from the Financial Crisis signify that the crisis revealed the vulnerability of the U.S. economy to the failure of any one part, particularly the overleveraged banking system that was weighed down by un-payable subprime mortgages. Moreover, the interconnectedness of the financial system meant that every company was a domino, and when one fell, others followed.
Notably, the pressure on regulators to fix things was tremendous, and Buffett commended them for their heroic efforts in stabilizing the economy. The government stepped in and bailed out the financial system, and the Fed took unprecedented measures to boost the economy and stock market. Buffett's belief in the resilience of the U.S. economy never wavered during the crisis, and he used his strategy of being "greedy when others are fearful" to make favorable investments in blue-chip companies. The lessons learned are clear: the U.S. economy is fragile and interconnected, and strong regulation is necessary to prevent future crises.
Source: Allianz
The CEO of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) has reportedly discussed potentially investing in U.S. regional lenders amidst the current banking crisis with White House officials, according to Bloomberg. This move echoes his crucial role in funding companies during the Financial Crisis, which resulted in profitable investments for Berkshire Hathaway. However, while his backing could calm fears of more bank failures and reassure depositors, it may not be as lucrative as his previous crisis-era investments due to smaller struggling lenders and competition from other potential saviors.
Nevertheless, Buffett's involvement could inspire confidence in the financial system and encourage other investors to hold on to bank stocks or purchase them at lower prices. As his financial stocks have recently decreased in value, calming the situation could benefit the banking industry and Berkshire Hathaway's portfolio.
Takeaway
In conclusion, the recent failures of banks such as Silicon Valley Bank and Credit Suisse have raised concerns about the financial sector's stability. While there are few similarities to the Financial Crisis, regulatory measures have been taken to prevent a full-blown contagion. However, the need for comprehensive depositor protection and risk management by banks remains crucial. Policymakers are taking steps to prevent the failure of other banks and avoid a potential banking crisis.
