The financial system and its fantasies
'Psychology of the masses' (Gustave Le Bon, 1895)—when digitalisation drives deposits, a new psychological phenomenon is the price, says Michael Lienhard
Everyone has rationalised why there is a growing list of collapsed US banks—so far the tally includes Silicon Valley bank, Signature, and First Republic. When the dust settles, things may look clear and logical but, ex-ante, how are we investors going to deal with an additional dimension of systemic risks that cannot be explained by an appeal to rationality?
Rethinking credit and systemic risks
As credit investors we deal with default probabilities, or, for those which see the glass almost full: survival probabilities.
The negatively skewed return distribution of credit risk is derived from the combination of a capped upside—meaning that the investor can only earn a certain amount of interest on their investment, regardless of how well the borrower performs—and full downside risk—meaning that the borrower may default on their debt obligation, causing the investor to lose their entire investment.
Within a well-diversified and actively managed credit portfolio, the return compensation tends to outweigh the pure default risks.
Investing in credit risk of large international enterprises can create good income, unless a tail-event—a global pandemic, war, or financial crisis, for example—occurs. In other words, we are here to model, assess, analyse the probability of ‘unthinkable’ and put a price on it.
From a simplistic top-down perspective, company specific risks have to be put in context with so-called ‘systemic risks’. If you look at safe haven companies like Nestlé or Johnson & Johnson, the credit spread—a good barometer of economic health—consists mainly of systemic risks, as company specific risks are deemed as minimal.
Therefore, even in the hypothetical case that the company-specific risk is zero there is no ‘risk-free yield curve’—as there is no company or financial instrument in the world that is not exposed to the interconnected global financial system.
That system is vulnerable, the systemic risks attached to it have a price, and the number of variables behind that price has increased. Variables that are not so easy to explain, but this credit investor shall try.
Paying the price of psychology
Digitalisation has transformed all aspects of life, making information and money more easily accessible and transferable to everybody. This has led to a gigantic merger of ‘masses’. Like a mass wave in a football stadium, or a murmuration of starlings, we are increasingly susceptible to the influence of others. In the financial system, anticipation for what ‘others might think’ partially supersedes rational arguments.
The GameStop phenomenon—where a host of amateur retail traders sent shares of GameStop Corp rocketing—and the recent banking sector turmoil have a link. Some might say a weak one, some might say a strong one, I believe it’s a critical one: ‘fantasy’ is now fixed in our financial system, with little means to ever unfix it. Instead, we must learn to work with it.
Fantasy and the financial system
Fantasy is a powerful feature of the financial system, stemming from the natural by-products of technological evolution, financial consumerism, mass-media and globalisation—not to mention an absolute awareness for the extent of the global multi-crises like climate, conflict, covid, and now credit.
These developments have become prominent forces in all areas of the system, which helps us understand why markets behave so erratically in modern-day finance. But there is one area in the financial system where mass behaviour is not adequately considered: risk controls. This, in my view, is an urgent issue when it comes to controlling the risk of bank runs that, thanks to digitalisation, can happen in a matter of hours not weeks and can help fuel mass fear and contagion like that which we recently witnessed.
Digitalisation and deposits
We waited a long time to transition from Basel II to Basel III to have better liquidity and capital ratios in banks. However, ‘capital good plus liquidity good, so all good’ does not work in a world of digitalisation and heightened risk of consumers being able to pull their deposits.
Additional guarantees, liquidity backstops and related measures may have to come fast. In addition, bank bond investors should grow suspicious of any CEOs or CFOs tweeting that ‘everything really is fine and capital and liquidity ratios are strong.’ This might just be the equivalent of ‘I don’t want to comment on the problem’.
For sure, decent capital and liquidity ratios offer a certain degree of reassurance. However, during the recent banking sector turmoil it was the deposit beta and price-to-book ratio which have driven the fears. Deposit heterogeneity may help as much as strong ratios. Geographically dispersed and highly fragmented banks like Santander or HSBC are good representatives of the ‘what-about-them’ group and may turn out to be safer banks from a credit perspective than many better capitalised financial institutes that are exposed to deposit contagion. Meanwhile, as a long-term credit investor, I’m most interested in what this new development means for understanding the broader systemic risks prevalent in markets.
The big squeeze
The efforts by central banks to bring down core inflation by raising interest rates have not (yet) sufficiently worked. Instead, it has led to cracks in the banking sector which have caused an immediate tightening of financial conditions as lending standards become more restrictive.
Derived from that there are two scenarios:
The first assumes that the financial tightening was enough to ‘provoke’ more defaults, layoffs and finally a weaker consumer, so that economic growth will deteriorate in sympathy with inflation. In this case, bond-equity tandem will break meaning that bonds would start to diversify equities again, after an extraordinarily high correlation which lasted a long time.
The second sounds more optimistic and assumes that the financial tightening is not enough to decisively bring down business activity and growth. While this is undoubtedly a good scenario in the short-term, we fear that this will kill any interest-rate pivot-fantasies meaning higher rates for longer. The problem with this is that investors and institutions holding big sums of US Treasuries as their ‘safe-haven’ allocations will continue to lose money. In this scenario, it’s possible to link the recent banking turmoil to a (too) supportive fiscal policy regime. In other words, the supportive action to avoid a recession has muted the impact of higher interest rates, causing them to climb even higher, which ultimately hurts bond holders, leading to deposit-squeezed bank runs.
Fiscal stimulus leading to bank runs—as people buy Treasury Bills and GameStop—is not my cup of tea to comment on. The main takeaway is that there is new force driving systemic risks which credit investors must price accordingly. For the glass-half-full investors, there’s as much opportunity as there is challenge. Crucially, we must never underestimate the power of the masses.