Understand the banking operation in 2023 - Case studies of SVB and Credit Suisse

With the current situation hitting several world banks, it is important to understand the role of the bank, its operation, and the reasons why SVB and Credit Suisse recently went bankrupt.

The role of banks:

Banks play a key role in the economy by accepting customer deposits and using these funds to grant loans to individuals and businesses. Here are some missions that the bank must manage:

• Accept deposits: banks accept deposits of individuals and businesses, which they keep in different types of accounts such as checks, savings, and monetary markets.

• Grant loans: banks use the deposits they receive to grant loans to individuals and businesses. They charge interest on these loans, which allows them to earn money.

• Risk management: Banks must manage the risks associated with the granting of loans. They assess the solvency of borrowers and make decisions regarding the approval or refusal of loan requests.

• Invest: banks also invest in various financial instruments such as shares, obligations, and common funds to generate additional income.

• Provide services: banks offer a range of financial services to their customers, such as online banking, credit cards, and financial planning advice.

• Maintain reservations: banks must also maintain a certain amount of reserves to meet customer withdrawal requests and comply with regulatory requirements.

Element to remember 1: Debit vs Credit of banks

In the bank's accounting assessment, deposits (customer savings) are found in the passive (debt) of the bank, while the credits granted to individuals or companies are in the assets (goods) of the bank. Concretely, the bank operates in the opposite way of individuals/companies, where our debt is in the passive of our accounting assessment, while our goods (houses/apartments) are on the side of the assets. Banks must also maintain a fraction of deposits (savings - booklet/livret A/LDD/etc.) which they receive as a reserve, called a mandatory reserve. This compulsory reserve is set by the central bank (European/Australian/Fed-USA) and varies according to certain criteria such as:

1. Bank size;

2. The type of deposits;

3. The economic situation.

Banks must therefore keep a certain percentage of customer savings as a reserve and can lend the remaining funds to borrowers. For example, if a bank has 100 million euros in deposits and the compulsory reserve is 10%, the bank must keep 10 million euros in reserves and can lend the remaining 90 million euros. However, the amount that the bank lends will depend on several factors, such as the solvency of borrowers, the type of loan granted, and the risk management practices of the bank.

Element to remember 2: a concrete example of the operation of state obligations:

For a state obligation purchased 1,000 euros, with a coupon of 1% (which means that we will receive a payment of 10 euros each year (1% of 1,000 euros - constant), over a period of 10 years, if the Interest rate directing increases to 5%, so we will prefer to buy bonds with coupons of 5% rather than bonds with coupons of 1% (yield of 1% <yield of 5%).

Consequently, the value of our state obligation by 1,000 euros with a coupon of 1% will decrease. The price of the obligation should drop to 691 euros to offer the same return as the new obligations. Sum of coupons of 10 euros over 10 years to 5% plus revaluation of the price of the obligation at 10 years to 5% also. 691 euros (new bond price) / 1,000 (initial price)) - 1 = 30.9% decrease.

In conclusion, if interest rates increase, the price of existing bonds decreases, which makes their return less attractive compared to new obligations issued at higher interest rates.

Once these two crucial elements have been understood, then we can calmly talk about the cases of Silicon Valley Bank (SVB) and the Swiss credit, which both have completely different issues.

Silicon Valley Bank

History:

SVB, known to be the start-up bank, was founded in 1983 by three businessmen who intended to work with companies that could otherwise have struggled to obtain loans from established lenders such as Wells Fargo or Bank of America. The bank therefore provided funding for technological start-ups that traditional lenders refused to finance.

It was part of a new wave of investment that emphasized the growth speed of a business, rather than its profitability. Classified 16th largest in the United States in 2021, with more than $ 212 billion in assets, and having an influenced influence in the technological industry, which represents 10% of the American economy, it declared bankruptcy in March 2023.

What happened:

During the pandemic in March 2020, federal interest rates in the United States were almost zero (0.5% until May 2022). A zero interest rate policy is generally implemented when there is a period of economic slowdown or recession whose aim is to encourage loans and expenses to stimulate economic activity.

However, this can and has led to excessive inflation and debt. During this period, the Silicon Valley Bank, therefore, invested billions of dollars in US government bonds, considered a safe investment. But when the Fed began to increase interest rates to combat inflation, the prices of these obligations dropped (read items to remember 2), because the new vouchers issued by the government offered higher interest rates (Fed interest rate - 4.5/4.75%) and became more attractive to investors. The fact that a large number of customers remove their money from the bank at the same time, due to their losses of trust, and this causes a situation called a "banking crisis".

The fall of Silvergate Bank, Silicon Valley Bank, and Signature Bank in recent weeks has aroused fears of a new financial crisis of the 2008 level, after the bankruptcy of Lehman Brothers which had resulted in global credit markets, finally leading to the worst economic recession since the great depression. It is important to note that SVB is very different from Lehman Brothers because it focuses mainly on technologies in the Venture-Capital industries, so the economic damage of this fall will probably be limited to this sector of the economy. Silvergate and Signature Bank focused on the crypto industry, which represents a tiny fraction of the economy. Thus, although the three recent falls can certainly have impacts within their respective industries, it is unlikely that they alone can cause a broader recession.

Credit Suisse

History:

Credit Switzerland is a whole different story. The Swiss Bank is an important systemic financial institution worldwide, with operations in more than 50 countries. If Credit Suisse was to collapse, the benefits would be much larger than for SVB. The Credit Suisse action course has dropped in recent years in recent years, losing almost 90 % of its value since 2018 (84chF in June 2007 against 21chF in March 2009 and 0.82chF in March 2023), the S 'decline recently accelerating.

What happened:

Since the subprime crisis, the bank has faced major problems:

1. tax evasion;

2. Criminal fraud concerning the financing of the Mozambique fishing industry;

3. Espionage of a former employee suspected of taking his clients;

4. Greensill Capital scandal with a loss of $ 5 billion due to the bankruptcy of Archegos Capital Management.

Despite attempts at repeated restructuring, 2022 turned out to be an even worse year for the Swiss bank. For each quarter, the declared net profit was negative, even after adjustment for the litigation and restructuring costs.

All this was not only the fault of Credit Suisse because the splendor years of 2020 and 2021 were followed by increases in interest rates and reductions in stock market prices, resulting in a decrease of more than 80% of the introductions On the stock market in 2022, which negatively affected all investment banks. However, Credit Suisse was particularly affected since it also reduced margin loans in its brokerage activity, following the disaster of the company Archegos. The total turnover of the investment bank division of Credit Suisse decreased by 53 % compared to 2021, but it was not the worst new one.

The bank's jewelry was not its investment bank, but rather its wealth management franchise, which helps wealthy people manage their money. Many customers from Credit Suisse, who lost money due to Greensill obligations, were furious and the Archegos fiasco again reported a lack of competence in 2022.

Customers, therefore, began to withdraw their money from Credit Suisse, and the assets of their wealth management went from 740 billion Swiss francs in the fourth quarter of 2021 to only 540 billion in 2022, a decrease of 27 %. The outings were particularly important in the fourth quarter, with a loss of around 100 billion Swiss francs for the bank.

Following the deterioration of financial performance, Credit Suisse’s action price began to decrease harshly throughout 2022, and when Australian journalist David Taylor relayed that a large investment bank was On the verge of bankruptcy many Internet users supposed that Taylor was talking about the Swiss bank.

The situation becoming very worrying and Credit Suisse needs to reassure its shareholders, it reveals a restructuring plan over 3 years in order to put the bank back on the right track:

1. Cession of their investment bank activity (sale of First Boston);

2. Massive reduction in staff (9,000 layoffs-20% of their workforce);

3. Sale of part of their group of structured products;

4. Additional capital lift.

As of December 31, 2022, Credit Suisse had tangible assets worth 528 billion Swiss francs and liabilities of 486 billion Swiss francs. This gives them a tangible accounting value of 42 billion Swiss francs, which means that the bank is solvent. But that does not necessarily mean that it is safe because approximately half of the assets are loans granted and are only due in several years, so not immediately available.

After having subtracted these loans as well as certain other illiquid assets, the bank has only 190 billion Swiss francs from immediate liquidity, compared to 226 billion Swiss francs from customer deposits and other liabilities, which can be removed at any time. Thus, although the bank is solvent, its passives exceed its assets of 36 billion Swiss francs. This means that if all its depositors and other counterparts withdraw their funds at the same time, the bank collapses.

Consequently, the bank announced that it would borrow up to 50 billion Swiss francs from the Swiss Central Bank in the context of preexisting credit facility to buy its own obligations in difficulty, and on March 19, UBS announced that It bought Credit Suisse in order to save the banking system from a potential systemic crisis.

This episode of the banking crisis is far from finished with inflation above 6-7% and central banks that are torn between increasing rates to lower inflation, at the risk of aggravating the banking crisis and bond or leaving rates at their current levels but leaving inflation at very, or too high levels.