Credit Suisse and First Republic: contagion fears for the FTSE 100

One week from the collapse of Silicon Valley Bank — essential reading for those out of the loop — and the much-feared financial contagion seems to be slowly spreading both domestically through the US, and into the international markets.

While banks seek the financial equivalent of masks and vaccines, depositors and investors alike are considering their institution of choice at a speed that years of switching incentives could only have dreamed of.

Small US banks have borrowed a total of $164 billion from the Federal Reserve, a new record compared to the $111 billion borrowed during the 2008 financial crisis. And about $300 billion in assets have been added to the central bank’s balance sheet, a significant reversing of the quantitative easing programme, regardless of how this is accounted for.

However, this is not 2008 — that crisis was sparked by the weakness of bank balance sheets, over-exposed to the collapsing US housing bubble via toxic mortgage-backed bonds. By and large, banks have much stronger balance sheets than in the past, enforced by post-crisis regulation. Admittedly, this regulation has only been tested in theory until now.

Instead, the current problems are fundamentally a result of rising interest rates starting to ‘break’ things. Investors are of course looking for the weakest gazelle in the herd — and as interest rates may continue to rise in the near-term given the ECB’s recent decision — banks are incentivised to take less risk with their capital, which could initiate a credit crunch.

And off course, reducing rates now could send inflation spiking. But this crisis is arguably the natural capitalistic result of the aberration of ultra-low rates across most of the western world for over a decade.

First Republic in a nutshell

First Republic is fighting a war on two fronts.

First, Secretary of the Treasury Janet Yellen has advised that while Sunday’s extraordinary step demonstrates regulatory ‘resolute commitment to ensure that depositors’ savings remain safe,’ she has also denied that the expansion of FDIC deposit insurance at two smaller institutions represents a blanket government guarantee.

First Republic caters to the high-end market and had more than $212 billion in assets at the end of December, generating more than $1.6 billion in net income last year. But S&P Global data shows that because it serves high net worth individuals and businesses, 68% of its deposits were above the $250,000 limit and therefore were uninsured. This has led to significant depositor outflows, a concern despite its reported $70 billion in liquidity.

Second, unlike the depositors, Silicon Valley Bank investors have not been bailed out, and face losing their entire capital. Accordingly, Fitch and S&P have downgraded First Republic shares, which have fallen by circa 80% over the past two weeks.

To re-instil investor confidence, a consortium of larger banks including the Bank of America, Goldman Sachs, and JP Morgan among others have deposited $30 billion in the bank — ironically these titans are likely the benefactors of the outflows.

They argue that ‘the actions of America’s largest banks reflect their confidence in the country’s banking system. Together, we are deploying our financial strength and liquidity into the larger system, where it is needed the most.’

However, judging by the share price, this action has not been enough — and a sale may be in its best interests.

Credit Suisse contagion

Credit Suisse's problems are not a new phenomenon. It lost £6.6 billion last year, and has endured multiple scandals including corporate espionage, alleged misconduct, sanctions busting, money laundering and tax evasion. Accordingly, clients withdrew a whopping £109 billion in 2022.

But things can aways get worse — with Switzerland’s second-largest bank recently reporting ‘material weaknesses’ in its financial reporting controls. And this week, the Chair of its largest shareholder, Saudi National Bank’s Ammar Al Khudairy, warned that his country’s central bank would ‘absolutely not’ provide additional liquidity, citing statutory reasons.

And Credit Suisse has been bleeding this week — Morningstar Direct data shows that $450 million was withdrawn between Monday and Wednesday alone.

To stem the crisis, the Swiss National Bank has offered to loan Credit Suisse $53.7 billion, in a show a show of support from the lender of last resort to ‘pre-emptively strengthen its liquidity.’ Additionally, the central bank has noted that ‘Credit Suisse meets the capital and liquidity requirements imposed on systemically important banks,’ which are more stringent than at smaller banks like First Republic.

The central bank together with the Swiss financial regulator have advised that there is no ‘direct risk’ from the current US market turmoil. But Credit Suisse shares remain down by 26% this week, and to certain investing predators might be looking like the ailing gazelle with a dodgy knee.

Ultimately, continuing to rescue banks from their own errors risks encouraging ‘moral hazard,’ where banks behave as though here are no real consequences to their risk-taking. In the case of Credit Suisse, the Swiss population which often governs by referendum may start to think about whether the bank that is ‘too big to fail’ might be better managed under government control.

FTSE 100 banks

The global financial architecture, like the markets, is an interconnected web of both self-evident and opaque connections which means that one diseased bank can rapidly infect a dozen others. FTSE 100 banks — including HSBC, Barclays, Lloyds, and NatWest — are tangled in this web, and have seen share price falls accordingly.

Of course, fears of a second financial crisis — whether real or imagined — have also weighed on Brent Crude, which has dropped to just $72/barrel, just $2 above the 2021 average. Demand destruction could also diminish demand for the metals of the FTSE 100 miners in a worst-case scenario.

After reaching its record high earlier this year, the index has lost 600 points this month alone, and further falls could start to apparate if central banks fail to walk the tightrope between managing inflation and preventing contagion.

And worryingly, that tightrope seems to be stretched across Cheddar Gorge.

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