Transcript
Speaker: Hello and welcome to the third installment of our look at the health of the global financial system and in particular the banking system.
Speaker: Joined as always by Ben Ashby,
Speaker: wealth of experience in banking.
Speaker: And I think it's fair to say when we started this series a few months ago, we were aware there were issues in the banking system, some funding issues.
Speaker: We had the zombification of the bank's balance sheets with their large stock of treasury holdings that are now somewhat difficult to dispose of.
Speaker: But fast forward a few weeks and things have probably moved a little faster than we were anticipating.
Speaker: I think
Speaker: We thought some of the issues would arrive in the second quarter rather than the tail end of the first quarter.
Speaker: And here we find ourselves on the 26th of April.
Speaker: First Republic has just reported questions on whether it can survive and actually questions about whether the banking crisis, as some people call it, is already over.
Speaker: Was it just a little localised issue at SVB and others?
Speaker: I think it's fair to say our view is it wasn't.
Speaker: This is a much more systemic issue.
Speaker: Yeah.
Speaker: that the Fed has contributed to.
Speaker: I don't think the Fed really understands the full implications of its quantitative tightening, in particular the reverse repos and how that interacts with the fund flows into the money market mutual funds.
Speaker: And I think we're probably still several months away from a resolution to this.
Speaker: And in the meantime, people are asking, is this 2008?
Speaker: I think there are shades of 2008, but it's certainly very different.
Speaker: What do you think, Ben?
Speaker: I don't think it's 2008.
Speaker: I think that a lot of the large banks are in much better condition, both in terms of assets and liquidity and capital.
Speaker: So while I think it's still early days and can be quite messy, I think that it's unlikely to morph into something like that.
Speaker: That said, the key thing for me is it's still early days.
Speaker: And I think there's several other very obvious shoes to drop, if you excuse the expression, to go forward.
Speaker: I certainly think it's early days.
Speaker: We've been looking at a simulation for likely bank deposit growth, for bank asset growth over the next year.
Speaker: And you really have to try very hard to get a turn up in deposit growth or credit growth this year.
Speaker: Much more likely to be tail end of the first quarter next year, I think, before we see an improvement in the credit growth.
Speaker: in credit conditions, and certainly effective credit conditions for real-world borrowers.
Speaker: And I'm finding that comes as a surprise to many people.
Speaker: You hear so often that the Federal Reserve is easing, it's providing emergency funding, it will take treasuries off the bank's hands and lend them funding.
Speaker: And so many people, I think, see this as a sort of QE, whereas I think I would view it as...
Speaker: the Federal Reserve making sure that granny doesn't lose her deposits in the bank.
Speaker: This is a way of preventing a Great Depression-style failure in the banking system.
Speaker: But it's not an easing.
Speaker: It's an accommodation of a demand for settlement cash within the banking system.
Speaker: Do you think that's the right way of looking at it?
Speaker: Yeah, I'd absolutely agree with that.
Speaker: I've seen some charts where people have said, look, not as many banks are failing now or indeed in 2008 as what we saw historically.
Speaker: And they take the example of the savings and loans crisis in the 1980s, which from memory was the all time spike in US bank failures.
Speaker: The point I would make is the banks that are failing now are materially larger than the things that we've seen previously and the scale of the intervention from the Federal Reserve is also larger.
Speaker: So running through the kind of issues as you've described, the first thing is QE was shoving cash onto your balance sheet when you didn't want it and you were happy with what you already had.
Speaker: What's happening at the moment is they are replacing cash that has exited your balance sheet that you really wanted to keep hold of in many cases.
Speaker: And like I say, that's a complex issue.
Speaker: There are certainly some banks that will be quite happy to see some of these deposits drain off their balance sheet because of how the regulation works and it grosses up their balance sheet, to use the terminology, and actually pushes down their return on equity.
Speaker: So they would be quite happy to see some of this go.
Speaker: But that's not what's occurring for a lot of the small and medium-sized banks.
Speaker: The second thing that happens as well is you have this perception that whether it's money borrowed from a central bank swap rate, say Bank of Japan, or whether it's from the Federal Reserve, that this is business as usual type money.
Speaker: No, it isn't.
Speaker: Because the moment you start borrowing on that line, management starts to get extremely unhappy about why they're now borrowing on an emergency line.
Speaker: Your regulator gets very unhappy about why you're borrowing on an emergency line.
Speaker: And effectively, it's an overdraft facility.
Speaker: to buy you time to get your life in order.
Speaker: And that would be one of my concerns.
Speaker: So I'm not sure when this goes out, but I would be surprised if one of the banks that's in the headlines that you've mentioned earlier manages a safe exit from this.
Speaker: It's not to say they can't do it, but the scale of the problem, the current market conditions,
Speaker: And what they need to do in the timeframe all looks like a big ask to me.
Speaker: So I would be moderately surprised if they're still here in a few weeks' time.
Speaker: In fact, possibly even a few days' time.
Speaker: Yeah.
Speaker: And also, I mean, using emergency funding.
Speaker: I mean, in a world of social media and rumours, you're one social media story away from a bank run if the perception is that you're a weak bank.
Speaker: And I think, hey, that is a big change, even from 2008 years.
Speaker: You don't have to queue in the rain to take your deposits out anymore.
Speaker: You swipe left on your smartphone or whatever it is nowadays.
Speaker: And I think another issue is there is a degree of uncertainty in bank funding.
Speaker: There's a degree of uncertainty over the short, medium and long term outlook for the banking system.
Speaker: And that's plainly going to affect the way in which banks are behaving.
Speaker: I think it'd probably be fair to say that most banks are assuming that asset growth is going to be minimal, if not negative.
Speaker: That means they're not going to be providing credit to the real economy.
Speaker: And yes, there are some very cash generative companies in the US, but the rump of the corporate sector is still cash flow negative.
Speaker: It has a working capital requirement and there's tightening in credit conditions that's occurring because of what we're seeing.
Speaker: It can't help but reverberate around the real economy.
Speaker: For the US, this is, I think, quite a major headwind.
Speaker: And it's something that ultimately the Federal Reserve will have to, I think, recognise.
Speaker: But it's not just the US that's affected by this.
Speaker: I think perhaps we're seeing more signs of stress in the realm of global credit flows in the cross-border sector.
Speaker: flows and some of the BIS data really does look quite stunning in terms of the degree of deceleration we're seeing in global credit flows and the effect that's having on activity in places like Asia, some of the other emerging markets.
Speaker: What's your sense on the state of global credit flows at the moment?
Speaker: Before I move on to that, I just wanted to pick up a couple of points.
Speaker: There are various tactics that you can do.
Speaker: So I know there's a perception that you can strip the entire deposit base out of a bank in hours now because of what's gone on.
Speaker: But there should have been a fair bit of deposit modeling by any competent asset liability management team about what are my deposits?
Speaker: What do they look like?
Speaker: What do my customers look like?
Speaker: What do they look like under stress?
Speaker: You've also got a range of tactics as the bank...
Speaker: itself or any competent bank should have about reducing those outflows.
Speaker: And one of the things you can potentially do is something called deposit throttling, which is a series of tactics about slowing down how quickly those deposits go out.
Speaker: The one that was interesting for me moving on to international credit is Credit Suisse, because as we discussed, they pretty much fitted every single criteria in terms of GSIB requirement, which is the sort of superclass of bank at the top.
Speaker: But they still lost a load of their deposits.
Speaker: Now, one of the things that's not properly understood is most of the major banks have idiosyncratic risks.
Speaker: There's always a few things that impact you.
Speaker: And I think we talked about HSBC in Hong Kong.
Speaker: But of course, one of the problems that Credit Suisse had was it had high net worth individuals.
Speaker: who probably wouldn't take very well to deposit throttling.
Speaker: It's a little bit like gating your deposits.
Speaker: Your customers are generally very unhappy about it when you do it, but it was probably not a feature that they could implement.
Speaker: On the international credit flows,
Speaker: I don't know.
Speaker: I've been surprised by the weakness of the dollar.
Speaker: We've discussed before about the chances of the dollar being replaced, and we think it's close to zero in any sort of short, meaningful timeframe.
Speaker: But I've seen people that I respect who attempt to calculate international liquidity, and they say it's going through...
Speaker: a boom.
Speaker: Now, where my concerns would be is I have a suspicion that they treat fungible, they treat all these kind of creations of additional money and credit in various large economies as fungible.
Speaker: I don't think it is, particularly when you get to the subject of China, because obviously you've got capital controls.
Speaker: And also in the case of Japan, because of various other kind of plumbing related issues.
Speaker: But there is already a very, very heavy use of the yen in terms of swapping it into dollars.
Speaker: And I'm not sure how much the international appetite would be for going forward for that.
Speaker: You also had the Japanese bank year end in the 31st of March.
Speaker: So they tend to be quite heavy borrowers going up to that.
Speaker: And I wonder if we're just being misled by the data.
Speaker: But
Speaker: Yeah, I'm surprised by the weakness in the dollar, and I would expect still problems to start occurring into international fund flows.
Speaker: I think so.
Speaker: And I think a lot of the notion that global liquidity picked up really relates to a couple of specific issues.
Speaker: In December, we had the BIS reporting about large settlement risk in global dollar credit markets, and the Fed did seem to take its foot off the brake for a while, certainly with regard to quantitative tightening.
Speaker: And even their interest rate guidance softened a little bit.
Speaker: We had the Corroda's last stand, as I called it, where the Bank of Japan was trying very hard to prevent JGB yields from soaring by adding, you know,
Speaker: insane amounts of liquidity in my view.
Speaker: But in the last few weeks, we've seen a lot of these things reverse.
Speaker: The Fed is still doing QE, I'm sorry, QE quantitative tightening.
Speaker: We have the reverse repos continuing to rise at the Federal Reserve despite what's going on in the banking system.
Speaker: But most of all, the Bank of Japan is now selling JGBs.
Speaker: It's actually shifted from a mega QE to quite an aggressive quantitative tightening to hold JGB yields up.
Speaker: In Europe,
Speaker: We're seeing the European Central Bank unwind the TLTROs.
Speaker: That's draining a lot of funding from the European banking system.
Speaker: So I think there was a little ripple of global liquidity late December through January into a week or so of February.
Speaker: But that's reversed, I think.
Speaker: If we look at the weekly data, I think we've got quite a tightening of growth.
Speaker: of global liquidity conditions.
Speaker: Very tight in Q3, a bit better in Q4, but deteriorating again.
Speaker: And as I say, I think that's really having an effect on the emerging markets.
Speaker: It's not often I'm surprised by economic weakness, but the export data coming out of Asia
Speaker: the inventory data in Asia, all of it is telling a very consistent story of quite a rapid slowdown.
Speaker: So I think that credit stringency that's really been visible for six months or so, notwithstanding that couple of months where it had a counter trend bounce, is exerting quite a big impact on global growth.
Speaker: And I suspect the next shoe that drops will be some defaults and delinquencies, particularly in some of these global credit flows.
Speaker: We've seen a lot of defaults related to China, but I think this could become more generalised.
Speaker: Again, we're seeing it in the really low-income countries.
Speaker: That's starting to make the headlines.
Speaker: But I think we've probably got a big default cycle in global finance in front of us over the next few months.
Speaker: Yeah, I agree.
Speaker: And that's why I still think it's early days.
Speaker: I mean, the credit cycle hasn't even started yet.
Speaker: So we've discussed about commercial real estate that looks seriously impaired in many cases.
Speaker: So we've still got that to work through.
Speaker: We're almost certainly going to find there's a few corporates that were, shall we say, overly aggressive, whether in terms of leverage or their business model.
Speaker: So again, I am expecting that to come through, and I would expect that probably to start in the second half of this year.
Speaker: But as we discussed before offline, 2024, to my mind, was a lot of the stuff when it starts to come home.
Speaker: So there's a couple of misconceptions I wouldn't mind sort of addressing.
Speaker: One is people saying, oh, look, the conditions are normalising.
Speaker: Well, they're not normalising.
Speaker: You can see from the funds flow from deposits that money's still leaving the banks.
Speaker: It's just not fleeing it at quite the same rate.
Speaker: But as long as rates stay high, I think you're going to see money coming out of the banking system, which will automatically cause tightening.
Speaker: And as you've discussed, it's a lot of it recycled basically back into the Fed where it has far lower credit multiplier effects into the real economy.
Speaker: So that's still to hit the...
Speaker: And, yeah, I would expect emerging markets to be one of the people that are going to really strain under this, because if you can get 5% at basically U.S. bills, everything else gets repriced from that point.
Speaker: And then it gets to the point, well, where do I want to price up Tajikistan bonds?
Speaker: So I think they're around about 15% at the moment.
Speaker: So you've got a lot of companies that when they come up to refi, that's going to be problematic.
Speaker: But this is the next thing I want to address.
Speaker: In the credit market, particularly with the younger members, there's a view that companies only default when their actual...
Speaker: bonds come up for maturity or their loans come up for maturity and they can't afford to repay them.
Speaker: That's not actually true.
Speaker: What tends to happen is when the company can see its end is in sight and it might be two or three quarters out, but it wants to have enough cash to have some control over its fate.
Speaker: That's when they often start to signal that they're not going to make it.
Speaker: That's when they often start to have the discussions about restructuring.
Speaker: because they've still got some cash where they can control events.
Speaker: And you've also got the liability side of things of the offices of the company about actually taking it into insolvency rather than attempting to deal with it instead of trading why you were insolvent.
Speaker: So again, for me, a lot of this stuff, I think, will perhaps start to come through in 2024.
Speaker: which is a question I have on the market about are we seeing something that's a bit like 2007 where we all know things are bad, but actually the equity market's got a bit longer to rally and then it's into 2008.
Speaker: Or is it the case that actually, you know, we are going to start seeing much bigger problems in the second half of the year?
Speaker: I think it's still more likely to be the second half of this year, but I could well be wrong.
Speaker: There's still a lot of pockets of liquidity in parts of certainly the US system, which might support equities a bit longer, for example.
Speaker: I must confess, I think the speed of the deceleration I'm seeing in Asia, the weakness in credit and this fundamental change in lending behaviour by US banks, I think it probably brings us into the second half of this year, albeit at the end.
Speaker: In the simulations that we've been running on the outlook for credit growth and deposit growth,
Speaker: it sort of suggests that conditions are going to tighten all the way into December, and I think that will derail the economy.
Speaker: Now, there's a silver lining in that, in that a global recession should deal with the inflation threat.
Speaker: Now, the central banks may still be looking at data points,
Speaker: inflation data points, in a way, are backward-looking.
Speaker: But probably in three or four months' time, I think they're going to have to start taking notice of just how weak the global economy is and realise they probably need to stop fighting the inflation war and start thinking about what comes next, which I think could turn out to be quite a dramatic easing in 2024.
Speaker: But in that moment of stress, and as we've written in an article in The Banker, I do think those offshore financial centres look quite vulnerable.
Speaker: I mean, if I was a bit cheeky, I'd almost suggest Switzerland was something of a giant offshore financial centre.
Speaker: It couldn't save Credit Suisse.
Speaker: Clearly, some of the smaller centres where you've got five or six billion dollars domestic deposit base, but a half a trillion dollar foreign book.
Speaker: There's nobody going to rescue those if we get some stresses.
Speaker: So I think...
Speaker: These issues in banking are going to reverberate around the offshore financial centres and these centres probably need to reconsider their business models.
Speaker: They are, I think, uniquely exposed to what looks like a fairly sort of evolutionary period for global banking.
Speaker: I couldn't agree more.
Speaker: But the only thing I would say is in the Cayman Islands, the SVB depositors did get saved by the US taxpayer, which I thought was quite remarkable.
Speaker: Now, I appreciate there's some technicals behind why SVB had that came in operation to do with some of the overseas investment in other jurisdictions.
Speaker: But it's a tough optic to explain to US taxpayers and politicians about why these entities were getting bailed out.
Speaker: And I would say, yes, Switzerland very much is an offshore banking center.
Speaker: And it clearly was at its limit.
Speaker: didn't seem to work for Credit Suisse.
Speaker: So they forced this, to my mind, fairly ugly merger, which again, I kind of get the general cost side of things, but I'm not sure from a client side of things that this is going to be a great deal.
Speaker: And yeah, I think there's a lot more to come.
Speaker: To my mind, there's somebody very close to Switzerland that I would certainly be asking questions of now that you would say, well, look, as a magnitude, this offshore centre in Europe has even bigger liabilities than Switzerland with even less ability to finance them.
Speaker: But I mean, they're not the only one.
Speaker: It's important to differentiate.
Speaker: There's two or three things that are going on, though.
Speaker: So you've got money that's actually parked over there.
Speaker: That is definitely where I'd have a level of concern.
Speaker: You've got the guys that have stuck fairly close to funds banking.
Speaker: I think that's much more complicated with offshore funds.
Speaker: And while there are definitely vulnerabilities, that is probably a lot more robust.
Speaker: But the other area we don't really discuss is the use of special purpose vehicles, SPVs, to route financing through some of these jurisdictions.
Speaker: And again, picking on some of the areas around the Caribbean, I think there's two or three of those that have been used by sovereign entities to source funding that they didn't necessarily want the mainstream dollar market to know.
Speaker: And I think those could potentially come under quite a lot of strain and surprise people in the next 12, 18 months.
Speaker: Certainly in the geopolitical environment as well, there is a backdrop, obviously, in some of this stuff.
Speaker: The Cayman Islands probably benefited from its geography.
Speaker: Some of the places further from the US and perhaps not in the perceived circle of trust might find it harder to be rescued, I think.
Speaker: That's exactly what I think is happening.
Speaker: You're going to end up with two worlds.
Speaker: You're going to be friends of America and able to finance off that.
Speaker: And I think it's going to be increasingly difficult when you're outside of it.
Speaker: And as we wrote in the article, another question I would have is,
Speaker: If I'm looking at my bank and I'm seeing some of the clients basically remaining offshore, but moving to, say, offshore accounts held out of New York or London or somewhere like that, then you've got to start wondering about, well, why am I staying here?
Speaker: Why am I staying with this discrete overseas bank with a bunch of people that are effectively unbankable by anybody else?
Speaker: It just seems a recipe for trouble for me.
Speaker: Yeah, you tend to get tarred by the company you keep if you're not careful, I guess.
Speaker: And we probably ought to think about wrapping this up.
Speaker: But I think our conclusions would be very much that there is more to run.
Speaker: The issues in the banking system have not been solved with a little emergency funding from the Federal Reserve.
Speaker: And I think most importantly, the banking system has changed its behaviour with regards to its provision of credit to the system.
Speaker: And that must affect the real economy.
Speaker: And I think it is the headwind or the
Speaker: The last shoe that drops to give us what could well turn out to be a global recession, certainly a disinflationary event in 2024, we'll probably be looking at how to deal with defaults, delinquencies, how to restart the global economy and how to get liquidity back in it.
Speaker: And some of the work that we've started to do suggests restarting this system may involve quite a lot of effort by the central banks.
Speaker: Yeah, sadly, I agree on that one.
Speaker: I don't think there is going to be any kind of short term normalization.
Speaker: And I have difficulty predicting anything like a soft landing because I think you're still to see the full impact.
Speaker: And just another point that when we discussed at the beginning of these podcasts, I said that investing your deposits basically in short term U.S. bills is one of the most capital efficient things you can do.
Speaker: Making overseas loans to other financial institutions is one of the least capital efficient things you can do because you get penalised for complexity because you're lending to another financial institution and you also get penalised because it's cross-border.
Speaker: So if you're sitting there as a bank wondering just how big the shock's going to be next year, if you're wondering about when your deposit flow is going to finish, if you wonder what the regulator's going to do, because they've obviously been blindsided by a chunk of this, so you know they're coming back to almost certainly ask for more
Speaker: then why would you basically go and start lending materially overseas unless it's an incredibly large pickup?
Speaker: When you can actually do this, the regulator will be happy, the politicians will be happy, and the shareholders will be happy.
Speaker: I think that's a very valid theme.
Speaker: Well, thank you for your time, Ben, as always.
Speaker: Third episode of this topic, and I strongly suspect there will be further episodes in due course.
Speaker: Thanks again.
Speaker: Thanks as always, Andrews.
