THERE’S a new horseman of the apocalypse: ‘banking mess’ has joined war, pestilence and famine. Fresh on the heels of Jeremy Hunt’s novel Budget seeking to deliver growth by increasing taxes on company profits, we have a string of banks falling over. While there is no direct causal relationship there is a unifying theme – poor thinking. Ewen Stewart has written definitively on the Budget so this is about the current banking struggle.
First of all remember that a bond is a promise of a stream of future payments by someone (the issuer) who wants cash today. Those will comprise a series of interest payments (the coupon) and the final payment will be to return the principal. For example, an issuer seeking £100 today might promise annual five coupon payments of £5 on March 20 for five years and on the maturity date, March 20, 2008, the £100 principal will also be returned. Investors value the promised cash flow, the impact of inflation and the risk that the issuer might default and come up with an offer – perhaps £95. If the issuer accepts he gets the cash and the investor gets the bond at the price offered, £95, not the £100 nominal (par) value. If at some later date the investor needs his money back he can sell the bond at the market price. Of course, that price will differ from the one that he paid, although in a stable world with a well-regarded issuer it should be about the same (as inflation and the risk of default haven’t changed the valuation maths).
The ‘stable’ bit can cause problems. If something changes for the worse in the issuer (or the market’s perception of the issuer), many holders of that bond will seek to convert their bond to cash, with the intention of buying something else. This creates a surfeit of sellers and the value of the bond will fall. This fall, which can become a crash, gives bond holders the unenviable choice of selling the bond for less than they paid for it – thereby crystallising a loss – or holding on to the bond in the hope of a recovery through some fiscal deus ex machina. The former course threatens solvency, the latter kicks the can down the road, possibly creating a zombie bank full of uncrystallised losses.
Unfortunately for everyone, we’re facing a systemic problem in the strongest bonds. The safest of safe havens, US and UK government bonds, have a problem. In short, fixing inflation has led to substantial interest rate rises so new bonds have significantly higher coupons than older ones. At the same time the value of the bond at maturity is falling due to the inflation that the interest rate rise is supposed to fix. Bond yields (the coupon divided by the bond price) are rising. As the coupon payments of a bond are a fixed amount the only way that yields can rise are for prices to fall. If yields double the price has halved. The charts below (from Marketwatch.com) are alarming.
In both UK and US yields have more than doubled, which has had a very negative impact on bond valuations. For this to happen in the (allegedly) safest, strongest elements of any bank or investor’s portfolio is worrying. For those investors who were always planning to hold the bond to maturity it’s tiresome, as is the fact that the principal might be worth less than they thought it would be. But that’s a future problem.
For those investors who purchased the bond as a safe haven for their or their customers’ capital it’s a disaster. Their assets no longer meet their liabilities (unless they have managed to hedge the position – although hedging brings its own costs and risks.) Even if shareholders invest to cover the loss, nervous customers may wish to withdraw their funds, in cash.
The long-accepted practice of fractional reserve banking means that banks do not have to hold cash reserves which match 100 per cent of the value of customers’ deposits; no bank has sufficient cash at hand to return all its customers’ deposits immediately. If there is a question on the solvency of a bank (triggered by either publicly crystallising a loss or a shareholder publicly refusing to invest, as happened to Silicon Valley Bank and Credit Suisse respectively) then customers will demand their cash. Knowing that the bank doesn’t hold enough to pay everyone, the prisoner’s dilemma kicks in. Facing an increased demand for cash the bank faces the prospect of selling more assets, probably into a declining market thereby risking insolvency, or going to its government and asking for support – which ultimately means taxpayers’ cash unless forced marriages can be arranged.
This is what is currently playing out in the markets as central banks deal with inflation by raising interest rates (which is about all they can do). The inflation had two causes. Firstly the energy price spike caused by Putin’s invasion of Ukraine – which has now pretty much resolved itself as prices are more or less back to pre-invasion levels. The second was the fix to the previous financial crash and Covid, namely Quantitative Easing (QE), also known as ‘Modern Monetary Theory’ or – perhaps more accurately – the Magic Money Tree.
This was embraced with gusto in the US, the UK and the eurozone. We were assured by its proponents that in the modern world interest rates would remain low and governments can print money (which is what QE is) to their hearts’ content. Today’s politicians loved the idea while those adults who remember the 1970s were less enthusiastic, and now we are reaping the whirlwind. The only possible cure for QE-induced inflation (increasing interest rates) is imperilling the solvency of the entire banking sector. Again.
Of course, the previous bail-out (that is, the 2015 transfer of money from unborn taxpayers to then participants in the financial markets) was supposed to be the last and to bring in new regulation. Banks of ‘systemic importance’ have their policies examined by regulators. The Bank of England runs stress tests which inform the process of what capital reserves a bank must hold (effectively defining the fractional reserve). The problems are that this process is necessarily historic and previous performance is no indicator of future value. Secondly, also of necessity, it uses models, which are not reality and are incapable of considering events or parameters which are not explicitly represented in them. Moreover, the test is limited by the imagination of the tester. In 2021 a European war or interest rates rising 20-fold in one year may have been unimaginable, and thus not considered. Oops!
While there is a blame game to be played here, I don’t think it’s relevant – other than to make the point (once again) that the titans of finance, the self-styled masters of the universe, are part of the problem. So too are innumerate politicians and weak-minded mandarins who serve them (at our expense).
The system is broken; the tragedy is that we, the people, have no power to hire the economists capable of fixing it. Neither ‘Sunak and Hunt’ nor ‘Starmer and Reeves’ can possibly be the answer when they are the problem.