What next for Banks in wake of CoCo crisis from Credit Suisse and Rising Inflation?

Blain’s Morning Porridge – March 22 2023: What next for Banks in wake of CoCo crisis from Credit Suisse and Rising Inflation?

“Don’t know what they’re doing but they laugh a lot behind the green door…”

This morning: Just how vulnerable are banks to further contagion and crisis? With inflation still running loose, central banks still set to hike, while consumer and corporate pressures mount, the banking crisis may only just have started.

What next for banks….? There was exactly a year from the run on Northern Rock in 2007 to the collapse of Lehman in September 2008. That might be a hint this crisis has a long way to still to run…

If you were looking for a bad sign, then UK inflation jumping to 10.4% for Feb this morning might be as bad as it comes, unravelling the expectations of talking heads arguing inflation will swiftly fall across Western economies over the next few months, and central banks can start to ease up on rate hikes. Nope. Rates are going higher.

It looks like we’ve got higher-for-longer price pressures on the UK economy, with the risk that will drive higher wage demands (although more UK unions are showing a willingness to negotiate wage settlements.) The pressure on central banks to keep hiking is set to rise… and as the last few days, higher rates have been shown to be really bad news for banks.. forget the nonsense about higher margins being good for them.

The consequences of 15 years of overly cheap interest rates are coming due – 15 years of bond issuance bought at 100% is worth considerably less today! The details on the higher than expect rise in UK inflation are worrying – core inflation (stripping out the volatile energy, food and alcohol numbers) is stronger than anticipated – and that can only fuel wage demands – which means the Bank of England will really struggle to get sticky inflation pressures back below 2%.

Today, the Fed decides on US rates. Its’ decision will be based on what it knows about how the inflation war is really going – and its desire not to panic markets about financial stability by going soft on addressing inflation. But if they hike, and further panic follows? Damned if they do, damned if they don’t!

As for the banks – expect more volatility. Yesterday saw the first respite from selling pressure across banking since the current crisis kicked off two weeks ago. In the US, names like First Republic bounced off their lows… although the bank is still trading lower than where it collapsed last week, around 10% of its valuation last month. European Additional Tier 1 Capital CoCo deals – for the better banks – bounced upwards a couple of points as the market decided Credit Suisse might just prove a one-off event.

Does the fact prices have bounced mean this mini bank crisis is over? Or has it just begun…..? When I read First Republic has hired McKinsey to advise on its strategic options, well what clearer signal to sell could there possibly be?

It helped the ECB and Bank of England came out against the decision of the Swiss regulator, Finma and the Central Bank to trigger the CoCos – putting some support underneath Europe’s stronger banking names. The central banks confirmed they would not have allowed the Swiss model whereby the debt holders of Credit Suisse’s $17.5 bln of AT1 Contingent Capital bonds were written off before equity holders in order to support market stability. (That worked well then…?) The market consensus is the Swiss decision was destabilising, but that’s what the bond documentation and prospectus clearly allowed them to do. It was a classic wake up to reality market moment.

The last few weeks has been extraordinary – 2 US banks gone, and following one mistimed/careless comment by its largest investor, Saudi National Bank, we had the cataclysm of negativity that sunk Credit Suisse over the course of just a few days. Reading through the noise its clear Credit Suisse’s swift quietus became inevitable once the chain of events and consequences kicked in.

The questions are multiple.. including who is next?

One obvious answer might be Deutsche Bank – another European bank with an unsurpassed ability to trip over its own shoelaces. Although DB has been proving its credentials as a banking basket case for decades, its Germany’s last surviving banking champion. It’s actually difficult to imagine what more it could do more wrong to trigger a similar string of consequential events that could sink it as swiftly as Credit Suisse was. Moody’s says Europe’s SIFI banks are fine – which is another sell signal for me!

More likely is the next crisis will develop within one of Europe’s larger retail/commercial national champion banks – hit not just by rising European government bond yields, but consumer stresses, falling house prices, falling recoveries on auto-loans, general slowdown and recession as banks cut lending leading to rising corporate defaults, unemployment and crashing commercial real estate crisis.

That’s the real issue – probably not a single idiosyncratic failure like Credit Suisse but multiplying points of real economic failure emerging in coming weeks. At the core will be:

1. Consumers – who have lulled the market into a false optimism though apparent high spending over the holiday season, but are now seriously battening down consumption in the face of persistent inflationary expectations, and
2. Corporates – finding it difficult to secure lending from more nervous banks, being unable to refinance existing debt, facing falling demand and rising costs on the back of rents and inflation. They will scale back investment as rising defaults and potential recession fears mount.

As the economic outlook deteriorates and the market remains febrile, the AT1/CoCo crisis is unlikely to be over yet. The CoCo financial instruments are likely to become a legacy issue for banks, their credentials as an investible form of bank capital are irrecoverably tarnished and discredited, but that will give them value. They will become a specialist market niche where brokers (like myself) will sieve the documents, prospectuses and holders, and the bank data looking to measure how robust the deals really are.

A key factor will be trigger points. What the Credit Suisse debacle highlighted was the AT1 capital did not provide a capital cushion for the bank. Although Credit Suisse had a 14% Core equity level, the perceived 8% level which would have triggered the CoCo’s actually became the bank’s irrecoverable crisis point. The reality is any bank that saw its CoCo’s triggered becomes a dead bank walking. In effect a relatively small diminution of a bank’s capital level (from 14% to 8%) could become its’ death sentence! The AT1 structure did nothing to buffer bank’s capital, but just brought the trigger point for systemic weakness further forward!

Despite SVB, American banks look much healthier – their regulator deciding what counts as core equity for a bank is just that… Equity or good old fashioned preferred debt (which most folk will happily acknowledge is equity with a bond like coupon.)

Finally, this morning, if there is one thing not to fall for in this tangled web of banking mayhem, it’s the message the crypto shills are pressing on the market. Bitcoin is up over 20% this month – apparently because its far more trustworthy that government fiat currency. How about this for a typical piece of crypto bullsh*t: “When the banking system is in peril, Bitcoin demonstrates it is independent from these risks and the whims of central banks.” Of course it is.

Five Things to Read This Morning

FT        Bundesbank chief says rate-setters must be “more stubborn” in inflation fight

FT        JPMorgan AM Chief warns on Commercial Real Estate risks

WSJ     The Fed Flies in the Dark

BBerg  The One Big Winner and Many Losers of UBS’s Credit Suisse Rescue

BBerg  Europe’s Top Banks Won’t Face Credit Suisse’s Fate, Moody’s Says

Out of time and back to the day job…

Bill Blain,

Strategist – Shard Capital