Does Indus Valley need to fear Silicon Valle

Does Indus Valley need to fear Silicon Valley?

The financial world has been grappling with the fallout from the collapse of a few banks in the West. In this note, we are taking a look at the potential impact on the Indian banking system. At the outset let us remember that the direct impact is limited. Most of Indian banks have limited global exposure and none have reported any significant impact from the global incidents.

Why should we pay attention anyway?

The financial crisis of 2008 reminds us that a financial crisis can spill over quickly to have a large real sector impact. If banks are unable to trust each other and if customers are unable to trust banks, we can see a sudden stop of liquidity and credit which can take a crisis from the banking system to the broader economy.

Already the 3 US medium sized regional banks which have collapsed this year (Silicon Valley, Signature and First Republic) have combined assets ($548 billion) greater than all the US banks that collapsed in 2008 (a little over $370 billion)¹. The failure of Credit Suisse which had a large investment banking franchise can be compared to the collapse of large investment banks such as Bear Stearns and Lehman Brothers in 2008. It makes sense to understand if there are similarities that raise concerns, or if the events are distinct from the experience of the 2008 financial crisis.

The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.

Was this unexpected or unforeseen? In a global stress test conducted by the IMF², several banks in developed and emerging economies would have seen significant erosion of capital. The global financial stability report foresaw these risks. Though the IMF report also did say that G-SIBs would not face a capital shortfall. Even this stress test missed Credit Suisse.

A banking crisis, but not a credit crisis

The first thing to note about the two bigger banks that failed in the US (SVB and First Republic) is that neither of them followed the typical template of a credit event. Though their business model was different, both banks had high quality, performing loans books. What brought them down was interest rate risk.

¹Source: US Federal Deposit Insurance Corporation

²Global Financial Stability Report, October 2022. G-SIB refers to Global Systemically Important Bank

SVB had a lion’s share of its assets in US treasuries, the global benchmark for risk-free assets. In a period of rising rates, these bonds have lost value. Even though these bonds were of long duration, they were not required to be marked-to-market as they were expected to be “held to maturity” (HTM). Those of us in the mutual fund industry or dealing with financial markets find this concept to be somewhat ridiculous. In India even liquid funds are marked to market daily. But the tradition for banks (including in India) is to hold bonds at cost even if the fair market value were to be much lower.

This can create a situation where the accounting position of the bank is healthy. SVB posted profits & had a “healthy” regulatory capital position. However its economic value was negative. That is a correct mark to market valuation of its assets would have resulted in a negative equity position (value of assets being less than the value of liabilities).

Rising interest rates on their own are not bad for banks. In fact, typically banks like rising rates because deposit rates tend to lag interest rates on loans during periods of rate increases. That is, banks typically see their net interest margins (at a basic level this can be understood as the difference between interest rates on loans and deposits) expand. SVB’s own internal analysis looked at rising rates as having a positive impact on Net Interest Income, while having a negative impact on the Economic Value of Equity³.

A crucial assumption in any model of risk is the assumption that the deposits stay put. Even if a bank has a large negative impact on Economic Value of Equity, it wouldn’t have to realize these losses unless it is forced to sell securities at a loss. That would happen if deposits started to flow out. A bank run forces the recognition of these losses. That was made worse by the concentrated and connected nature of depositors at SVB.

First Republic did not have a treasury mark to market problem. It had a healthy portfolio of residential mortgages (in US parlance: jumbo prime mortgages, those that are high credit quality but large sized). As is standard in the US, these mortgages were mostly long-term fixed rate loans. As interest rates rose, the value of this portfolio dropped. Note that unlike treasuries, these loans were not traded. In a sense, you could say that the “mark-to-model” value would have dropped. US mortgages also have the property that the duration rises when interest rates rise, compounding the mark-to-model valuation. Of course, this portfolio was also less liquid than the treasuries on SVB’s books.

For these banks, a large interest rate shock to the asset portfolio accompanied by deposit outflows (a run on the bank) led to their demise. It is a little ironic that for SVB, investments in a highly liquid asset could not save it from a liquidity crisis.

A bank run on a larger scale

Hemmingway once said that there are two ways to go bankrupt: slowly, then suddenly. That is the story of Credit Suisse. It cannot be said that the market wasn’t aware of the issues facing the bank. In five of the last 10 years, it posted losses. But it was a sudden run on the bank which eventually brought it down.

Note that CS did not have a capital problem, nor did it have a mark to market problem in the classic sense. Its assets (even at fair value) were in excess of liabilities. But the scale of outflows – about CHF 123 billion in 2022 and a further CHF 69 billion in the first quarter of this year – was such that it may have necessitated a firesale of assets (the chart below shows the movement in total deposits at CS). The Swiss regulators took the view that the bank had reached a point of non-viability (PONV) and arranged a takeover by UBS

The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.

³Source: Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank, US Federal Reserve, April 2023

The key outcome from a system perspective has been the decision to write off the Additional Tier 1 bonds of CS. AT1 bonds are hybrid instruments that – like equity – can be used to absorb losses. Similar to the decision of the Reserve Bank of India in the case of Yes Bank in 2020, the regulator decided to write down the AT1 bonds, but spared equity investors⁴. Remarkably, it is estimated that the total assets of CS exceeds its liabilities by about CHF 45 billion and its total capital was estimated at CHF 50 billion⁵. Both numbers are way more than the 13 billion of AT1 bonds the bank had issued.

Should we expect more such failures?

To a certain extent, restrictive monetary policy aims to reduce inflation by reducing aggregate demand. In market economies, this means raising interest rates to the point that it reduces the demand for credit from the commercial sector and reduces the lending ability of banks by raising the cost of deposits and tightening liquidity. Viewed from this lens, the odd bank failure may be seen as a feature rather than a bug of monetary policy.

That is not to say that there will be more bank failures. The IMF global financial stability report, for example, does not see widespread bank capital shortfalls in the developed economies (the chart below shows the distribution of banks by CET1 ratio⁶ in a stress scenario). A global recessionary environment might be more painful for emerging market financial institutions, especially those that are exposed to short-term dollar funding.

⁴Both these AT1write-downs are now being litigated

⁵Source: Annual report of Credit Suisse

⁶CET1 – common equity tier 1 ratio, the ratio of equity to risk weighted assets of a bank

The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.

So what are the implications for Indian investors?

We need to understand these risks from multiple perspectives: as depositors with banks, as investors in bank capital instruments, more broadly from a banking system perspective, and lastly to understand the broader macro implications of the bank failures.

A crucial component of the bank collapses this year has been the complete depositor protection even where the deposits were above the insured limit. In India also recent cases of failures of scheduled commercial banks have not resulted in depositor loss.

When it comes to bank capital instruments, the regulatory position now appears to be consolidating to putting AT1 bonds as junior to common equity when it comes to restructuring of banks. Investors in hybrid capital instruments should conduct additional due-diligence on the financials of the bank.

Indian banks are, in general, very different from banks such as SVB and First Republic. A recent report by Jeffries looked at Indian banks from the SVB perspective⁷. They found that deposits are more retail and diversified. That reduces the risk of a bank run.

SVB’s collapse was triggered by the losses on its HTM book. Normally banks report gains and losses on the AFS and HFT books⁸. Naturally there could be a concern on the HTM holdings of Indian banks. In the above report, Jeffries also estimate that the impact of marking to market the HTM book would on average reduce capital by about 6% for private banks and by about 15% for public sector banks. There may be some outliers with higher risk, but it appears that the systemic risk is relatively low.

In its financial stability report, the RBI has also looked at the impact of mark-to-market valuation of HTM bonds. The RBI estimates that the system level CRAR (capital to risk weighted assets ratio) will drop by 307 basis points if there were to be a 250 bps upward shift in yields. The RBI also calculates stress test by testing the mark to market valuation of the trading books⁹. On this basis it found that no bank would fall short of CET1 or CRAR minimums in case of a stress scenario (chart below).

⁷The SVB Test On Indian Banks: Sector Holds Up, Again! Jeffries, March 2023

⁸HTM – held to maturity, AFS – available for sale, HFT – held for trading. Regulations specify the frequency of mark to market valuations for AFS and HFT assets.

⁹Financial Stability Report, December 2022

The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.

We also believe that the various global bank regulators are being proactive to limit the spill-over effects of bank failures to the broader macro economy. The speed of bank resolutions on both sides of the Atlantic suggests that regulators are unwilling to repeat the mistakes of 2008, when an underlying weakening macro scenario was worsened by the failures of large financial institutions like Lehman Brothers.

To some extent this quick rescue appears to be working. The US Federal Reserve survey of Senior Loan Officers indicates that lending standards have remained broadly unchanged in April compared to January. This survey does show that lending standards have been tightening over the past several months in response to rising interest rates. This could have some risk to growth and earnings of companies in the quarters ahead as this chart from Morgan Stanley shows.

The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.

A slowing US economy is sure to have some effect on the rest of the world, and we need to be mindful of the risks that may appear in the year ahead. Central banks (and other bank regulators) appear to be quick to solve issues with banks given the experience of 2008, but as the pension fund crisis in the UK demonstrated, risks could come from an altogether new source this time around. We have to remain watchful as to where additional risks may pop up as this global rate hike cycle seems to come closer to its end.

Implications for monetary policy and interest rates

If central banks manage to contain inflation by slowing down the economy without a serious recession or banking crisis, we should rejoice. Global assets appear to be pricing in such a scenario with low long-term bond yields, low credit spreads and strong performance of equity indices.

The swift action to resolve these banks allows central banks to focus attention of monetary policy on bringing down inflation. If bank credit becomes harder to get, the trajectory of inflation could head lower more quickly. Since March (when the US banking issues came to light), the US Dollar index is down about 4%. The index is down about 11% from its October 2022 high. Some of this reflects a change in market perception about the evolution of the Fed funds rate going forward, i.e. there is greater expectations of a rate cut this year now than in early March¹⁰. The markets now appear to price in about 75 bps of rate cuts by the Fed this year and about the same from the RBI in the next 12 months.

The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.

We do not expect any direct impact of these bank resolutions on Indian policy stance, but if we see slower global growth we should expect RBI to act to protect growth. The RBI in its most recent monetary policy action stood pat on rates with greater confidence that inflation will remain below the threshold of 6% (though it is still unlikely that the 4% target will be met any time soon). An environment of lower US/Global growth and inflation along with a stable Indian Rupee could give room for RBI to change its policy stance in favour of lower rates later this year.

The above graph is used to explain the concept and is for illustration purpose only and should not used for development or implementation of an investment strategy. Past performance may or may not be sustained in future.

¹⁰Source: Bloomberg. Note that the chart does not start at zero to show variations better.

Even without the impact of the banking issues, it does appear that globally and in India, inflation is slowing. Thus the RBI is on pause and the US Federal Reserve has indicated that it would consider pausing in the near term. As inflation decelerates, it opens up the policy space for rate cuts. Over the past several months, we have been maintaining relatively higher duration stance across our portfolios with that view.

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