Paribus. The Fragility of Finance.

Despite a lot of turbulence in the markets this week the Federal Open Market Committee (FOMC) did exactly what was predicted. Jerome Powell carefully adjusted his language and reframed the narrative around his 25 basis point rate hike to try and calm the markets he had helped to damage.

His forward guidance was only to expect further rate increases if inflation spirals out of control. He avoided taking any responsibility for the recent bank failures, claiming instead that the sector was stable and robust.

In reality, the global financial system is teetering on the precipice of another crisis. For anyone who doubts this, they only have to consider Credit Suisse’s rapid fall from grace.

Although Credit Suisse has been embroiled in controversy over the past few years, so have many other large banks. In 2021 NatWest was fined £265 million for money laundering, in 2022 Barclays was fined $361 million over its issuance of securities, and this was after they’d already been fined $453 million for market fixing. Their past controversies weren’t what brought Credit Suisse to its knees before an unforgiving Swiss government.

Like every other major bank Credit Suisse had bought lots of government bonds when interest rates were low. Now that rates are significantly higher, those bonds are worth less than they paid for them.

Providing that banks don’t have to sell them quickly, the difference in yields between old and new bonds isn’t a problem. It only becomes one when they’re forced to liquidate them due to mass withdrawals, which is exactly what happened to Silicon Valley Bank and Credit Suisse. As soon as the public gets fearful and the markets smell blood it quickly becomes a death spiral of withdrawals and collapsing share values.

The problems affecting Credit Suisse also affects every other major bank in the sector. It wasn’t a case of lacking regulation, it’s a direct consequence of banks only holding a small fraction of depositors’ money, and the biggest challenge to banks at present is their complacency about this aspect of their operations.

Having spoken at length with bankers in both Europe and Asia it’s clear that they don’t have much fear of a similar situation happening to them. From their perspective, they hold higher reserves than in 2008, have better risk management, and pass all of their regulatory stress tests. In their opinion, they’re in better health than ever before.

The issue facing the modern banking system has more to do with the lack of understanding the public has about how banks operate and the fear that can quickly take hold as a result. The sudden lack of public confidence in any bank causes a drop in their share price and a flow of liquidity from their balance sheet. Governments and central banks realize how dangerous this can be which is why they acted so swiftly and dramatically.

For instance, the Swiss government forced Credit Suisse to be sold to UBS at a heavy discount in a very short period of time. They refused to give the shareholders in both companies any say over whether the sale went ahead or not and agreed to offset billions of dollars in losses involved in the purchase.

This rapid and unprecedented intervention shows just how at risk the entire market is of contagion. While politicians are trying to calm the markets and convince the public their money is safe, the picture inside the industry is somewhat different. Every banker we spoke to fully expects further banks to fail, although they’re convinced it won’t be their own.

Modern banking is commonly referred to as fractional reserve banking, which means banks only need to hold a small percentage of depositors’ funds in highly liquid reserves. The theory is that this should be enough to cope with withdrawals in most circumstances and high-demand cases. What they can’t cope with are extreme events such as mass withdrawals because they don’t have access to everyone’s money.

Centralized banking requires depositors to give away control of their money so that banks can leverage it to earn a yield. We’ve seen this system fail time and again in crypto and now we’re witnessing it occur on a much larger scale. When banks fail, governments step in, but what’s unusual now is that they’re guaranteeing everyone’s deposits, no matter how large.

The sheer scale of government support and intervention shows how at risk the banking system is to contagion. It is far from stable or robust. We’re living in strange times when politicians are claiming undercollateralized banks are safe and overcollateralized DeFi is unsafe. As George Orwell famously said, “In a time of deceit, telling the truth is a revolutionary act.”

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