Partner Content: Last month saw the unexpected collapse of two very different banks. Rob Evans from CCLA discusses the reasons for the recent high-profile casualties and highlights some of the risk management tools available to local government treasurers.
While the major global banks are now able to withstand much larger losses than they were back in 2007 when we approached the Global Financial Crisis, over the past six weeks we have all received a stark reminder that the security of bank deposits, over and above any deposit guarantee scheme, cannot be taken for granted.
In recent weeks there have been two high-profile casualties: Silicon Valley Bank (SVB) and Credit Suisse.
Although their failures were wrapped up in the same wave of panic and uncertainty, they each failed for completely different reasons. There were a number of red flags which should have forewarned treasurers as both banks were susceptible to potential issues.
SVB had grown rapidly since the start of the Covid-19 pandemic, due to huge deposits from technology companies and venture capitalists.
The bank poured most of the $130bn of new deposits made in 2020 and 2021 into government securities. More specifically, it bought tens of billions of Treasury and agency securities which had virtually no credit risk, but which would fall in price if interest rate expectations rose sharply.
It would ordinarily be good practice to limit this interest rate risk with a hedging strategy, but SVB did not appear to have one in place.
Securities slump
When interest rate expectations jumped, on the back of stronger-than-expected US economic data and hawkish comments from the chair of the US Federal Reserve, the value of these securities fell further.
This would not be a problem if the securities were held to their maturity. However, the bank simultaneously suffered large deposit withdrawal requests which prompted SVB to seek to raise capital to cover the booked losses. This spooked markets, ultimately resulting in a run on the bank and the bank’s very quick demise.
Subsequent interventions by authorities in the US meant that all depositors in the US were offered protection, while HSBC’s takeover of the bank’s UK subsidiary protected depositors in the UK.
The Bank of England governor Andrew Bailey said: “A blanket guarantee of all depositors is not costless. … It reduces the risk sensitivity of a bank’s funding, could result in moral hazard, and any costs would ultimately need to be borne by the taxpayer.”
According to the Financial Times, the Bank of England initially proposed putting SVB UK into Resolution, because it was not systemically important to the UK. However, its sale to HSBC was eventually agreed after the government and the UK founders argued that British start-ups would be disproportionately harmed if SVB UK was closed.
If SVB UK had been put into Resolution, all deposits above the Financial Services Compensation Scheme threshold would have been at risk.
Focus on Credit Suisse
The market’s focus then switched to Credit Suisse, which essentially managed to scandalise itself out of existence.
Credit Suisse lurched from one humiliating crisis to another, most recently being forced to delay its results following a call from the US Securities and Exchange Commission. In an environment where the market was looking to attack banking’s weakest link, its investors and customers simply lost faith in the bank.
CCLA’s deposit and money market funds (MMFs) have never been exposed to Credit Suisse, however, it is worth noting that $17 bn of junior debt holdings were wiped out because of UBS’ shotgun takeover.
Reassuringly, at this point we didn’t witness a detachment in bank Certificate of Deposit yields from interest rate expectations. If that had occurred, it would have demonstrated an increase in the risk premium of money market investments.
So, it does appear that soothing comments by central banks and the general consensus that these problems were not representative of systemic issues in the wider banking sector settled markets somewhat.
However, that should not be the cue for treasurers to drop their guard on the security of their bank deposits.
LDI crisis
We saw back in September 2022 that higher interest rate expectations had caused unanticipated problems within the UK liability-driven investment pensions market.
More recently the implications of a renewed jump in the interest rate outlook have emerged within the US regional banking sector.
So, it is by no means out of the question that another interest rate shock – perhaps on the back of further surprise changes in the Organization of the Petroleum Exporting Countries’ oil production, stronger inflation or concerns surrounding the strength of the housing or real estate market – could bring banks back into focus in the not-too-distant future.
15th Annual LATIF & FDs’ Summit – 19 September 2023
250+ Delegates from Local Government & Investment
Protecting deposits from counterparty risk
Diversification is of course the most effective way to minimise counterparty exposure, however, this may be easier said than done.
True diversification doesn’t only involve spreading investments across a group of banks or issuers, other factors should also be considered.
Under money market fund regulation, CCLA’s MMFs must ensure that exposure to an individual bank’s securities is limited to 5%, and we have a list of more than 50 approved financial institutions that we can lend to. But we go further than this when it comes to the diversification of our MMF investments.
Our funds operate within strict rules around geographic exposure. For example, banks in Canada are likely to face some correlated risks, such as the domestic housing market. We therefore cap the total exposure to Canadian banks.
The same could be said for UK building societies which all follow similar strategies. When creating CCLA’s approved list of financial institutions, we seek to achieve a blend of banks covering different areas of the global economy: some are retail-focused, some are large globally systemic banks, some have large investment operations; whereas others, like Standard Chartered, are UK-listed but focus on more emerging markets.
Analysis of banks
Assessment of credit quality is as important as diversification. To make it onto CCLA’s approved list of financial institutions banks must overcome a number of strict hurdles before they are creditworthy for our MMFs.
We have several tools that enable an in-depth analysis of banks, along with systems providing data feeds of key metrics, an option which may not be available to many treasurers.
Here are three less resource-intensive metrics that are easily measured and may be leading indicators ahead of an individual bank going through stress.
- Interest rates differentials
Banks may put out soothing statements designed to settle markets, but they are in reality best judged by their actions.
In the months leading up to SVB’s collapse, the market suddenly sensed the vulnerability of the banking system to the withdrawal of deposits – it’s crucial to know which banks were concerned about keeping their deposits.
One indicator is the average rate that banks were paying on interest-bearing deposits. It’s no coincidence that at the end of 2022, SVB was the second highest paying bank in the Nasdaq Bank Index.
A similar situation was observed with Icelandic banks in the years leading up to their collapse. Credit Suisse also followed this pattern over its last 12 months.
Keeping track of the history of an individual bank’s deposit rates relative to their peer groups or a benchmark, allows treasurers to identify spikes or changes in demand that can be a useful early warning sign.
- Maturity profile
The events of the last few weeks have demonstrated just how quickly things can change – we have seen a mainstay of the financial system like Credit Suisse disappear over the course of a weekend.
This shows how different grades of maturity limits depending on the strength of a counterparty may be a helpful tool in reducing risk and enabling a relatively short roll-off of investments, should a bank’s position deteriorate.
When making investments with a bank on CCLA’s Approved List of Financial Institutions, we apply further in-house views that grade our approved counterparties. This means that not all banks are treated equally, even once they are through the door.
Furthermore, should a bank suddenly start quoting a range of longer-dated tenures, having previously not done so, these actions should be assessed before any investment decision is made.
- Governance
Over the past few years, Credit Suisse was involved in numerous controversies, from Greensill Capital to the Tuna Bonds scandal in Mozambique, to even being caught hiring private investigators to follow employees.
While banks are not immune to controversies, a regular occurrence of them indicates a poor corporate culture and level of governance. Poor corporate governance will result in a loss of shareholder confidence, impede a bank’s capability to raise capital and ultimately damage financial performance.
Monitoring the financial press and setting up internet search engine alerts for news articles that flag stories about existing and potential bank counterparties can offer treasurers an important early warning of a bank’s deteriorating leadership and culture.
Other news events, not just controversies, may also offer insight into patterns that could cause problems further down the line.
Using SVB as an example – we saw that its rapid growth, from a largely concentrated client base, was evident from its own publications. This might trigger questions about whether this growth was sustainable or whether it was hot money at risk of being withdrawn en masse should market conditions change.
Reflecting on this latest period of stress, we see that while the potential remains for future crises to emerge, the increased capitalisation of the major banks means that the likelihood of any systemic 2008-style banking issues is low.
However, SVB and Credit Suisse have demonstrated that early warning signs could have brought some of these bank’s associated risks and failings to the attention of depositors prior to the banks’ demise, and could have led treasurers to limit their exposures well in advance of any issue becoming terminal.
Rob Evans is a cash fund manager at CCLA Investment Management.
Disclaimer
For more information and further updates, please see our website www.ccla.co.uk/insights. For regular online briefings, please see www.ccla.co.uk/events.
This document is a financial promotion and is issued for information purposes only. It does not constitute the provision of financial, investment or other professional advice.
To ensure you understand whether a CCLA product is suitable, please read the key investor information document and the prospectus. CCLA strongly recommends you seek independent professional advice prior to investing.
The Public Sector Deposit Fund (PSDF) is a UK short-term LVNAV Qualifying Money Market Fund.
In addition to the general risk factors outlined in the prospectus, investors should also note that purchase of PSDF shares is not the same as making a deposit with a bank or other deposit taking body and is not a guaranteed investment.
Although it is intended to maintain a stable net asset value per share, there can be no assurance that it will be maintained. Notwithstanding the policy of investing in short-term instruments, the value of the PSDF may also be affected by fluctuations in interest rates. The PSDF does not rely on external support for guaranteeing the liquidity of the fund or stabilising the net asset value per share. The risk of loss of principal is borne by the shareholder.
Past performance is not a reliable indicator of future results. The value of investments and the income derived from them may fall as well as rise. Investors may not get back the amount originally invested and may lose money.
Any forward-looking statements are based upon CCLA’s current opinions, expectations and projections. CCLA undertakes no obligations to update or revise these. Actual results could differ materially from those anticipated.
The PSDF is authorised in the United Kingdom and regulated by the Financial Conduct Authority as a UCITS Scheme and is a Qualifying Money Market Fund.
CCLA Investment Management Limited (registered in England & Wales, No. 2183088, at One Angel Lane, London, EC4R 3AB) is authorised and regulated by the Financial Conduct Authority.
—————
FREE weekly newsletters
Subscribe to Room151 Newsletters
Follow us on LinkedIn
Follow us here
Monthly Online Treasury Briefing
Sign up here with a .gov.uk email address
Room151 Webinars
Visit the Room151 channel
