Source: Bloomberg Finance, L.P.
Stocks are higher, and bonds are also higher broadly on the expectation of lower rates. Shall we just ignore this bank crunch or is there something to be learned? Below are our key takeaways from the current environment:
1. All banks rely heavily on leverage to generate margins and profits. None will have liquidity in short order to satisfy a bank run. As a result, there is a role for central banks to play in an emergency.
2. Deposit insurance has a limit; in Canada it is $100,000. Central banks can print unlimited amounts of money. As long as they are willing, money is not an issue!
3. Government bonds and T-bills are the safest investment as the borrower can print money to pay you, while banks cannot.
4. After the failures of Bear Stearns, Lehman Brothers, and Credit Suisse, investors should understand by now that no single bank is absolutely safe and they should diversify their investments by country, sector, and by names within the sector. It is the old saying, “don’t put all your eggs in one basket.”
5. The current shock will likely have implications:
a. Banks will be more defensive in lending, hence tightening credit conditions, especially for lower quality borrowers. This also means the risk of recession in the next six to nine months is higher.
b. Depositors are finding alternatives to deposits, such as T-Bills and money market funds, for higher interest and higher security. This means banks may continue to lose deposits not because of safety concerns, but price.
6. Central banks are influential on the banking system and economies. They have been more active lately as there were more crises than normal in the last two decades. The Fed balance sheet has expanded every time a crisis occurs and only shrinks marginally. It stands at $8.7 trillion today vs. $4 trillion in 2020.
The value of money is questionable, and probably does not get questioned enough. The resurgence of interest in gold bullion and cryptocurrencies suggests there is a growing force voting against central banks. Will they be able to mitigate risks and contain losses, or will further shockwaves hit the broader banking system?
Investors’ optimism turned sour in March as Silicon Valley Bank and Signature Bank failed, yet outlooks and markets rebounded on the expectation that the Fed would prioritize the banking system ahead of fighting inflation. The Bank Term Funding Program (BTFP) was launched to allow banks to borrow from the Fed using government bond holdings as collateral. This move showcased the vital role of central banks in a crisis, while also exposing the ability for cash to be manipulated and fuelling a resurgence of interest in cryptocurrencies and gold bullion as alternative deposits.
Glossary of Terms
Leverage: An investment strategy of using borrowed money – specifically, the use of various financial instruments or borrowed capital – to increase the potential return of an investment.
Liquidity: The degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. Cash is considered to be the most liquid asset, while things like fine art or rare books would be relatively liquid.