The overnight news that the Swiss Central Bank is making available SFR50bn to Credit Suisse comes as a great reassurance to markets. It is the job of central banks to offer last resort lending to large, regulated banks if confidence has waned in them and they need extra liquidity.
It is a reminder of the power and importance of central banks in any modern system of banking, where banks rely on the central bank to supply them with cash should many depositors wish to withdraw their money all at the same time. Central banks need to react as the Swiss central bank has – in a way which supports commercial banks subject to bear raids and unhelpful comments. This was a welcome contrast with 2008-9, when the Fed did not stand behind Lehman Brothers which led to deeper problems in markets. The Fed too moved to reassure when it faced the Silicon Valley bank problem.
All regulated banks allowed to trade are solvent, according to their regulators. If a regulator or central bank becomes worried about the solvency of any regulated bank, then it needs to sort that issue out in private with the bank and announce the solution promptly to the markets. Last week saw the resolution of issues with Silicon Valley Bank in a way which protected all depositors and was welcome for that.
Rates up, bonds down
In 2022, the main western central banks made clear their wish to see higher interest rates, taking down the bond markets. The Fed helped enforce a bear market in bonds by selling many of its own bond holdings at ever lower prices. This action was bound to cause distress amongst various categories of bond holder. We learned last week that included Silicon Valley Bank, which owned substantial bond positions which lost money.
The last week has been a sobering time for bulls of bank shares. As we pointed out before the crisis, whilst higher interest rates bring more revenues for banks on their loan books, they also bring more bad debts as some borrowers struggle with recession. They can bring heightened difficulties for banks trading and owning financial investments and lead to a demand to pay depositors more interest raising their costs of money.
The runs on a couple of smaller US banks unsettled bank equities, with big mark downs in the prices of the weaker banks of whatever size as investors started to look for possible repeats of what they had just seen. This culminated yesterday in the very large share price fall at Credit Suisse. We do not normally get bank runs because banks are highly regulated and wish to conduct their affairs in a prudent way. The authorities this time have moved swiftly to contain the damage and to stop bank runs becoming more common.
The action towards Credit Suisse is reassuring.
Banking is all about gaining and retaining the confidence of customers, so bank directors should have drilled into them the need to proceed carefully, weighing up risks. The model the US and Europe follows is fractional reserve banking. This usually works well, allowing banks to put plenty of money to work whilst still meeting all their obligations. If confidence in a bank is lost it no longer works for that bank.
If you deposit £1,000 in a modern bank in a current account where you can withdraw it at any time the bank does not take fifty £20 notes and put them in a safe custody box for you. They credit your account electronically with £1000 promising to repay and then put the £1000 to work in their business. They keep substantial cash available for those who want to withdraw, but it is a fraction of the total amounts they have taken in from depositors. Experience shows people do not all turn up and want their money back on the same day, and money withdrawn by one person is often put back into a bank account by another who has received the money as payment.
The regulators insist on the banks keeping sufficient cash and near cash to meet likely withdrawals easily and require the banks to keep enough money from shareholders and retained profits to cover any likely losses in a bad year. Banks’ assets include bonds, loans to companies and individuals, mortgages and other financial products. They usually keep a spread to reduce their risks to any sector or company.
The bank makes money out of two main features of its work. It may take short-term money it collects as deposits and lend it out for longer, as lending for longer usually produces a higher rate of interest. It may take its deposit money and lend it out at higher risk, as it will earn a bigger interest rate on lending to a higher risk customer. Get the higher rates high enough to cover extra losses and this can work well if they lend to enough different clients to avoid a high percentage overall loss rate.
Central banks vital to system
The system also relies on the work of the central bank. The central bank is the banker to the banks. They should lend to any regulated commercial bank which needs more cash in a hurry. If a bank run is developing, the central bank usually makes cash available for the bank to pay out the depositors, as the best way to stop a run is to show there are no problems with meeting people’s demands to get their money back.
The Fed this week has made clear it is providing additional facilities for banks to borrow should they need to, and it will be reasonable about the collateral it needs as security for the lending. As long as a bank is solvent it should not want for money to meet a run on its deposits. The central bank takes some of the danger out of lending long and borrowing short by offering to bridge the time difference if people want their money back.
If the regulators think a bank has become insolvent, they will move to close the bank down and get someone else to take on the job of managing the customers. If this fails then the bank is wound up with losses for shareholders and bondholders and sometimes for depositors as well, subject to local rules on deposit insurance and guarantees. In the US depositors benefit from a repayment guarantee of up to $250,000 and in the UK an £85,000 one.
This week’s events show that the rate rises and money tightening we have seen so far has been intense and is now having a real impact on a few banks and some trading companies. It will mean the Fed and the other leading Central Banks will need to rethink just how much higher they should take rates as they see the stresses the policy is creating. They do of course want inflation down and are impatient with the pace of its fall, but they also have a crucial duty to keep banking systems safe.
This is a new consideration for them as they had been working so far on the assumption that commercial banks could handle big rises in rates. They are discovering there is some limit to this capacity and should conclude that the severe monetary shock they have administered is going to cut inflation more. Banks alerted to the dangers will lend less and charge more for credit without further rate rises. We have just had another monetary tightening without rate rises as a result of these events.
We assume the central banks will continue to act promptly and decisively to prevent any more generalised banking problems. Most of the large banks are very well capitalised and able to handle current conditions without problems. The action towards Credit Suisse is reassuring.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.