Although recent headline-grabbing events within the banking system have moved the topic of a potential credit crunch centre-stage in the markets’ consciousness, the fact is that a credit crunch within the Global Financial System began a year ago, while that in the US domestic economy began late last year. More recently, Europe looks to have moved down the same path. Admittedly, the global situation did improve during December and early January, when global financial conditions eased for a variety of primarily technical reasons, but this has proved to have been only a false dawn.
Global Cross Border Bank Lending
% YoY BIS Data
The weakness in global credit flows has already taken its toll on activity rates within the EM and in particular within the Asian Region where we are seeing exports slump, inventories rise and production levels fall into quite significant recessions. Even China’s much-heralded Post Pandemic rebound has turned out to have been something of a disappointment.
More recently, in Europe and Japan, rates of credit growth have slowed appreciably and, in the USA, they have moved towards zero as banks have sought to conserve both capital and, importantly, their access to core (deposit) funding. This new credit stringency – it is not so much the price of credit but its availability that has become the issue – has already impacted the weakest links in the financial system.
Cash flow negative tech companies and struggling commercial property companies have so far been the epicentre of the problems, but over the coming weeks we expect these issues to spread. Indeed, the lack of credit and the exhaustion of the “Pandemic-era Pent-Up Demand” should result in the US falling into the type of dis-inflationary recession that the FOMC has been targeting during the second half of this year. We would not be surprised, given events in Asia and Europe if we find ourselves in a Global recession by the year end. Were it not for the glut of bond supply that is due to hit the debt markets this year, we would probably be buying US Treasuries today, even at these levels.
Why has this crunch occurred? The root cause of the problems within the Global Banking System go back to the Federal Reserve’s essentially panicked and badly calibrated use of asset purchases during 2020, and to a lesser extent 2021 (we would blame 2020 for the problems in the banking system, 2021 for the inflation…). During the opening weeks of the Pandemic Crisis, almost exactly three years ago, the Federal Reserve purchased $2.2 trillion of fixed income assets from the non-bank sector, and in so doing it created an annualized rate of growth in the money supply over sixty percent! Quite simply, neither the real economy – which suffered inflation – nor the financial system could cope with this degree of largesse.
The Federal Reserve’s unconstrained creation of money led to two significant events within the monetary system. Firstly, the volume of deposit liabilities in banks swelled by up to a third. With the banks’ liabilities blowing out for reasons outside of their control, the banks of course needed assets but they possessed neither the capital nor the desire to lend these funds into the real economy. Instead, they were obliged to acquire “low risk” bonds that attract a low risk weighting in their capital adequacy calculations. However, these bonds were anything but low risk in reality; in effect the banks were being forced to buy hundreds of billions of dollars’ worth of Treasury bonds at wildly inflated prices. Three years later, with inflation having taken a significant toll on the value of the bonds, the banks are now sitting on huge potential mark-to-market losses that are forcing them to warehouse these securities and thereby zombify their balance sheets. For those banks that have suffered deposit flight and which now therefore need to shrink their balance sheets by selling bonds, this situation has created an existential threat, as SVB proved.
The second impact of the Federal Reserve’s panic creation of money was an explosion in the assets under management of the Money Market Mutual Fund industry. This sector witnessed its AUM swell from $3 trillion to over $5 trillion, but the problem for the MMF has been that, under their regulatory environment, there are only $3-$4 trillion of cash assets that they can buy. Consequently, they have been obliged to make up the difference by borrowing Treasuries from the Federal Reserve in exchange for surrendering their cash back to the Fed. This is important.
When the MMF only purchased bills from the markets, as they did prior to the Pandemic, then they would in effect be returning the money that was being subscribed to them back to the wider economy (i.e. when they bought a bill from someone) but, when the MMF started giving the money back to the Fed, they implicitly took money out of the system and left it sterile in the Fed’s vaults.
USA: Money Market Funds
AUM USM trillion
This situation was bearable for a while but when the Fed’s Quantitative Tightening and the deposit-destroying dynamics of the country’s large current account deficit were added to the mix, the banks found themselves going from a deposit glut in 2020 to a deposit shortage in 2022. Having been short of assets in 2020, and therefore having had to inflate their balance sheets accordingly, they are now finding that they are short of (funding) liabilities and that therefore need to shrink their assets. Of course, with so many of their assets now tied up in deflated bonds that they could not sell, the loss of deposits has obliged the banks to stop lending to the rest of the economy. Hence the credit crunch that we are now witnessing. Historically, when credit conditions have been this tight, a recession has usually unfolded within a year.
USA: Credit Standard (Tightening) for Commercial Property
FRB Loan Officer Survey
It is our belief that in time the credit crunch will cause a recession and inflationary pressures will dissipate, at least to an extent. The Federal Reserve should then be able to – or obliged to - cease QT. At some point, the Debt Ceiling should also be raised and the Treasury will begin issuing bills again. The MMF will be able to buy these bills and so reduce their deposits at the Federal Reserve, thereby moving the sterile funds out of the Fed and back into the economy. This will then free up more liquidity. If the Fed also cuts rates at some point during the recession, then the scene should be set for a substantial liquidity boom in 2024, and the cycle will have been completed.
However, we do believe that there will be longer term effects from the crisis. SVB, Credit Suisse, Signature and others have revealed just how quickly a bank run can occur in the Digital Age. This is not 2008, when depositors had to queue to extract their deposits from a struggling bank such as the UK’s Northern Rock. Today, there can be a news story – fake or otherwise – that causes people to reach for their smartphones and begin moving their money. Even a mega bank could in theory face a run that saw it lose a tenth of its deposits quite quickly.
One solution to this new World order would be to make all bank deposits 100% insured by the authorities, but that would be prohibitively expensive in the largest economies, impossible in medium sized economies (as Switzerland proved) and inconceivable in highly geared small economies. In particular, the small population Offshore Financial Centres could not even consider such schemes. We do wonder, therefore, whether the now rather middle-aged model of commercial banking has reached its natural end?
As recent days have shown, the merest whiff of a bad bank will see deposits flow into large banks, T bills, or MMF (which as we have noted are simply conduits into the bills markets). Since Treasury Bills are a liability of the State, they are presumed to be risk free despite the fact that Congress seems to be doping its best to make sure that this isn’t the case by refusing to raise the Debt Ceiling!
Ultimately, we suspect that the authorities are going to have to create a genuinely risk-free liability of the State and this we suspect will take the form of a Central Bank Digital Currency (CBDC). These should not be confused with crypto currencies which are not true money – their value is not fixed in nominal terms and they are not usually legal tender. They are instead tokens that consenting adults are willing to exchange with each other, according to their preferences.
We suspect that the current digital-age banking crisis will hasten the move towards central banks providing direct deposit facilities to the private sector (they already do this for governments). The central bank will take in money and then (hopefully) loan that money to the (former) banks, who in turn then allocate the funds to would-be borrowers. The lenders will still need capital, they will need to be good lenders but – attractively for them – they will no longer need huge retail branch networks.
In a best-case model, we will end up with a highly efficient cost-minimizing credit system, although in a worst case we will have government interference forcing central banks to fund the authorities’ pet projects. The system could work well, or it could be abused. It is perhaps ironic that by having “blown up the system in 2020”, the authorities will gain more power of it. Of course, in reality, there will be good examples and bad CBDCs, a differentiations that we can presume will be reflected in the FX markets that should reward efficient systems and punish less capable systems.
In fact, we would argue that we are already slipping into such a World. To recap what we said earlier, in the USA today savers are quitting banks and then placing their funds in Money Market Funds who are then placing the money on deposit at the Federal Reserve. The Fed is then having to loan funds back to the banks so that they do not have to fire-sale their assets. Moving to a CBDC would simply formalize and simp0lify what is starting to occur anyway.
In the near term, investors must cope with the consequences of the credit crunch and recession, while looking forward to a probable liquidity boom during 2024. However, even while focussing on these short term tactical considerations, we should not underestimate by how much the Financial System will have to change over the next decade. There will be winners in this new world; as ever countries with central banks that can provide a sound store of value, albeit now a more digitized one, should do well. Other countries will however lag behind in the evolution processor simply abuse it, while others may simply find themselves becoming extinct. In particular, the days of the small offshore private bank could be numbered.
There will be those savers that do not wish to have their funds deposited in CBDCs for all sorts of reasons, with the result that there will still be a demand for alternative stores of value. However, we doubt that these will be in the form of old-style bank deposits – CBDCs will leave the remaining deposit takers weakened, as in all likelihood they will be pushed into the outer more colourful reaches of the saving markets. The days of the anonymous Swiss bank account are probably now behind us and the World’s Private Bankers are going to have to rethink their business models into a more efficient asset management model, or find a way to offer anonymous routes into the major CBDCs…
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