Crazy For CoCo Puffs?
Updated
March 22, 2023
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TLDR:
It’s not even been a few days, but this week’s events delve deeply into the nature of money and banking. We are at a turning point. The question is which direction are we going. Free market competition in banking vs. a nationalized banking sector.
On one hand, we have the proverbial invisible hand. This is supposedly how banks compete and provide better services for depositors, and keep their management in check unless they want to lose their customer’s confidence and experience a run on the bank.
On the other, there’s the realization that finance is inherently a highly regulated and special industry. Because of its systemic importance, and the potential disruption it causes everyone when it doesn’t work well, multiple regulators are in charge of various facets of banking in the US.
The sad truth is that we have the worst of both worlds right now. Banks are theoretically allowed to compete, but there is a plethora of regulations that they are required to follow. Even for “smaller” banks such as Silicon Valley Bank, these costs are very large. Regardless of how reckless SVB was in managing their interest rate risks, there is no evidence that any regulator pushed back on the enormous size of their Held To Maturity (HTM) portfolio which was more than 50% of all the assets of the bank. There’s pretty much no way for them to amass such a portfolio without the tacit ok from regulators.
And why wouldn’t they be ok with it? The Fed literally controls rates. Surely, they wouldn’t hike so much that it would blow up most of the banking sector’s liquidity portfolios right? Right?
So banking regulations today are like using a solid steel colander. It is very robust, but when things are leaking, it just doesn’t hold water.
What could a better banking system look like? I’d love to answer that question, please be on the lookout for a separate feature on this topic! Meanwhile, on the news of the last few days…
Swiss regulators have done a good job in calming the markets for a couple days with their $50B lifeline to CS so that they can hash out a longer term plan. It’s clear that $50B was not enough given its $575B balance sheet. So they have arranged CS to be sold to UBS.
I was surprised that a sale was in the cards given the series of missteps suffered by CS over the years. However, its collapse would likely cause damage similar to what was experienced during the great financial crisis due to Lehman Brothers’ bankruptcy. So there does not seem to be another way.
In exchange for going through with the deal, UBS received a massive amount of support from the Swiss National Bank, not least of which includes changing the laws to allow this deal to go through without shareholder approval and 200 billion francs of liquidity guarantees.
There is a slight uproar right now given a certain class of CS contingent convertible bonds (CoCos) that get “bailed-in” in case capital buffers fall. They have been completely zeroed out as part of this transaction, aptly so since they were made specifically to absorb loss in a significant stress event, but unusual nonetheless since equity holders were able to keep a few billion. There are some arguments on why that shouldn’t happen based on the fine print, we’ll let the bond holders fight it out.
Treasury Secretary Yellen had a very difficult testimony in Congress. Given the legal framework, only deposits at G-SIBs are fully guaranteed. It was a straightforward question for a legislator to ask. “Will the deposits in every community bank fully insured now… regardless of the size of the deposit?”
No? Then why wouldn’t everyone pull their funds from community banks and put them into the large national banks? Unfortunately, Yellen had no good answer for that. The even bigger question was however, would the Treasury have the authority to do that?
The answer seems closer to no. Which means that more work needs to be done in coordination with the FDIC to establish this as a measure if necessary. Some legislators have come out against an unlimited guarantee. Fortunately deposit flows seem to have stabilized and in some cases reversed, putting less pressure on regulators to act.
Over an extended period of time, such as 100 years, the dollar has lost 99% of its value.
Every time governments take extraordinary measures that flood the banking system, money supply increases and eventually, the purchasing power of that money decreases. Could the pace of devaluation be accelerating? That’s what Balaji Srinivasan contends is happening.
Not only is he contending this is imminent, he thinks this will happen within the next 90 days due to the unfolding banking crisis which will require yet again, a massive amount of stimulus via printed money.
He also shows historical data about previous hyperinflation regimes with the assertion that it strikes suddenly, meaning that we could well be on our way towards it without knowing it.
The most outlandish prediction associated with his claims however, is that Bitcoin is going to $1mm in the next 90 days. Now I have a certain bias for crypto, but even I am not that bullish.
But maybe that’s not his point. He is stating that he is partly using the outlandishness of the claim to get people’s attention before it’s too late. I sincerely hope that he doesn’t get such a critical mass that it actually causes hyperinflation to happen.
Every FOMC meeting has been more interesting than the last, and certainly this weeks’ will be given the utmost attention by the world. At the time of writing we are at approximately 70%+ chance of a 25 bps hike.
My own inclination is for the Fed to pause. Given the very fluid nature of bank runs now, it is much less likely that they will want to risk it by hiking to see what the collateral damage is on the ~4000 non G-SIB banks. There are already many laying the blame directly on the Fed causing the losses on the very securities they are requiring banks to hold. If inflation is still persistent, they can always hike 50 bps next meeting?
As for the structure of banking, never let a good crisis go to waste! There are many pieces coming out on potential reforms going from even more conservative banking, to something radically different. Lookout for my thoughts on this later this week!
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