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Dear Investor

General Market Overview

Despite positive headline index performance driven principally by the technology sector, the United States (US) banking sector has faced numerous challenges this year. These include rising interest rates, a slowdown in economic growth, and increased competition from non-bank financial institutions. As a result, some regional banks have struggled to remain profitable, leading to closures and mergers.

In 2022, there were 13 bank failures in the US, the most since 2011. Three notable failures include Silicon Valley Bank (SVB), First Republic Bank, and Signature Bank. The immediate cause of bank failures is almost always a run. No bank, however solvent, can withstand a full-scale run. To prevent bank runs, the US, like most countries, offers guarantees, through the Federal Deposit Insurance Corporation (FDIC), to depositors who have deposits of less than $250,000. These “smaller” depositors will be made whole whatever happens, and so have no incentive to run, whatever the state of the bank. The average bank in the US has about 50% of its deposits insured in this way. JPMorgan Chase and Bank of America have approximately 30% covered.

On the 1st of May 2023, the FDIC took over the assets of First Republic Bank, a $2.5 billion-asset bank based in California. This failure now represents the second largest in US bank history and the most significant bank failure since the 2008 Global Financial Crisis (GFC). This failure follows the FDIC takeover of SVB on the 10th of March 2023 and Signature Bank on the 12th of March 2023. JPMorgan Chase acquired most of First Republic Bank’s deposits and assets, paying the FDIC $10.6 billion as part of the overnight deal.

SVB’s failure with $212 billion in assets is the third largest failure in US history, just behind First Republic Bank. SVB was notable as it specialised in lending and providing banking services to technology companies. As a result, the bank had many clients with large cash deposits because of capital raised from Venture Capital (VC) firms. However, these capital-rich, start-up companies typically have little revenue or cash inflows from operations. At SVB, at the end of 2022, only 2.7% of deposits were covered by FDIC insurance. Several factors contributed to SVB’s failure, including a decline in the value of technology stocks, a slowdown in the technology sector’s growth, a surge in loan defaults, and, ultimately, a bank run.

At the peak of the tech investing boom in 2021, customer deposits surged from $102 billion to $189 billion, leaving the bank awash in “excess liquidity”. At the time, the bank piled much of its customer deposits into long-dated mortgage-backed securities issued by US Government agencies, effectively locking away half of its assets for the next decade in safe investments that earn little income by today’s standards.

In 2021, interest rates were still low, and bond prices were high. SVB’s bonds looked like a safe piggy bank. Then came the great inflation scare of 2022, during which the Federal Reserve (the Fed) hiked rates, and bonds suffered their worst year in history. Rough estimates suggest SVB sustained at least a $1 billion loss on its books every time interest rates went up by 25 basis points (bps), and the Fed has hiked by 450. As a result, if it had to sell its “safe” portfolio of bonds to fund customer withdrawals, it would suffer a considerable loss.

Simultaneously, technology companies started drawing down more heavily on their cash deposits as the availability of VC funding at lofty valuations dried up. As is the case with bank runs, it’s fine until it isn’t. On one day, depositors initiated withdrawals of $42 billion, the scale of which left the bank totally illiquid. SVB executives abandoned their attempt to raise $2.25 billion in “emergency capital”, and just a day later, the bank was declared insolvent.

Following the FDIC’s intervention, SVB was taken over on the 10th of March 2023, with its assets sold to First Citizens Bancshares for $10.5 billion.

It is tempting to compare the bank failures in 2023 with those in 2007/08. Both periods experienced a decline in economic activity, increased loan defaults, and a loss of confidence in the banking system. However, despite the material asset value of the current three bank failures, the number of failing institutions is quite different. In 2007, 140 banks failed, while in 2008, there were 2,355 bank failures in the US alone.

The US Government’s response to recent bank failures has differed from the Government response in 2007/08 in several ways. In 2007/08, the Government was slow to react to the growing crisis, and many banks were allowed to fail before the Government intervened. In contrast, the Government has been more aggressive in recent years in identifying and addressing potential problems at banks, including the requirement to increase capital reserves and undergo more rigorous stress tests.

The focus has been preventing bank failures rather than bailing out failing banks. In 2007/08, the Government bailed out many large banks, including Bear Stearns, Fannie Mae, and Freddie Mac. These bailouts were justified as a mechanism to prevent a collapse of the financial system. However, the bailouts were costly and unpopular. In recent years, the Government has provided financial assistance to banks in danger of failing, but it has not bailed out any banks. Another undesirable aspect of the 2007/08 bailouts was the secrecy of the Government’s actions. The US Government is working to provide increased transparency and reporting on bank stress tests and governance.

Overall, the US Government’s response to recent bank failures has been more proactive, preventive, and transparent than that of 2007/08. The current actions are a positive development from a regulatory perspective, although this doesn’t guarantee the current bank failures have been contained.

In global banking news, Swiss bank, Credit Suisse, is being taken over by rival, UBS, in an enormous integration exercise. Credit Suisse was rescued from collapse after it suffered a second heavy spell of client defections following a range of banking scandals. In mid-March, Credit Suisse was fined $475 million by US regulators, followed by a fine of $200 million imposed by United Kingdom (UK) regulators in April. The merger and integration with UBS are set to create a “megabank” with invested assets of over $5 trillion.

Banking distress comes amidst a backdrop of slower economic growth and increased inflation. With rising inflation, the UK, Eurozone, and Japan experienced slower than expected economic growth in the first quarter of 2023. UK inflation is now at 9% year-over-year (y/y), the highest level in 40 years; inflation in the Eurozone is 7.5% and 2.5% in Japan. While 2.5% y/y inflation in Japan is not excessive, this is the highest level in seven years and materially above the average experienced over the last five years.

Food price inflation is one of the components of the inflation basket that has risen sharply. The UK has the highest core inflation (excluding food and energy) and the highest food price inflation in the G7 group. The UK is not self-sufficient in food production for domestic requirements, and approximately 48% of food is imported from various countries. A weakening currency has meant that the price of imported UK foods has climbed substantially.

General Conclusion

The recent bank failures in the US have underscored the critical role of the banking sector in economic growth and development. Banks play a vital role in extending credit to businesses and individuals, facilitating investment, and supporting economic activities. The takeovers of First Republic Bank, SVB, and Signature Bank by the FDIC have raised concerns about the overall health and stability of the banking industry.

These bank failures come when the global economic outlook is one of slower growth and increased inflationary pressures. In many parts of the world, including the UK, inflation has become a persistent concern rather than a transitory phenomenon. Rising import costs and a weakening currency have contributed to a “cost of living crisis”, making imported goods more expensive and squeezing household budgets.

Given these circumstances, central banks face the challenge of managing their inflation-targeting mandates while supporting economic growth. While higher interest rates can help curb inflation, premature tightening may risk dampening economic activity and hindering recovery. Central banks must carefully assess the prevailing economic conditions and the persistence of inflationary pressures before deciding on interest rate adjustments.

A cautionary example can be seen in Argentina, where the central bank has resorted to raising interest rates to a staggering 97% to combat soaring inflation, reaching 108.8% y/y. This extreme measure highlights the potential consequences of allowing inflation to spiral out of control.

The global economic outlook for the remainder of 2023 will likely remain mixed. Central banks will continue to struggle between taming inflationary pressures and supporting sustainable economic growth. The pace and extent of interest rate adjustments will depend on the evolution of inflation, the resilience of the banking sector, and the overall economic conditions. We will closely monitor central bank actions and communication for signals of the path forward and the subsequent impact on investment markets.


12 June 2023

General Market Commentary Q2 2023
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