While everyone was focused on the fight to bring down inflation and stave off a recession at the start of 2023, a new financial crisis was brewing in the global banking sector.
On March 10, to the surprise of many, Silicon Valley Bank (SVB) collapsed after a bank run. In the immediate aftermath, other U.S. regional banks buckled, and the turmoil spread across the Atlantic with the fall of Switzerland’s second largest bank, Credit Suisse, which was soon rescued by Swiss regulators and UBS.
Over the past few years, conditions for Credit Suisse’s demise were building due to various risk oversight failures and management turnover. This was in contrast to the regional banking crisis, which appeared to run its course in a matter of days. The startling chain of events prompted the U.S. government to introduce new measures to stabilize the financial system and prevent future failures. It also triggered fears of a broader global banking crisis, including here in Canada.
So, why did these banks collapse, and is there a risk of something similar happening in Canada?
A confluence of events is likely to blame for the failure of the U.S. regional banks. The regional banking system became vulnerable to recent interest rate hikes intended to combat inflation stemming from the pandemic. U.S. regional banking had a disproportionate share of loan growth over the last four years, most likely due to lower regulation. The result was a crisis of confidence in the service that regional banks could provide and a proverbial “run on the bank” as deposits started to flee very quickly.
And while the government’s swift policy response alleviated some of the immediate panic around the regional banking crisis — a positive for markets and risk assets in particular — there continues to be an overall decline in deposits in American regional banks, which is likely to lead to lower credit creation if the larger banks don’t fill this gap.
This could have far-reaching implications, as small banks represent a significant portion of commercial and industrial lending in the U.S.
In Canada there is less concern about potential collapses, because the banking system is mostly concentrated within the Big Six Banks, which are larger and, therefore, more highly regulated. For example, Canadian banks are required by the Office of the Superintendent of Financial Institutions to maintain very conservative minimum liquidity ratios and hold adequate forms of liquid assets on their balance sheets. Evidence of the resilience of Canada’s banking sector lies in the fact that Canada has not experienced a bank failure in 100 years.
This is not to say, however, there won’t be any ripple effects in Canada. The banking sector will have some headwinds with potentially tougher regulatory scrutiny on the horizon, which normally leads to a squeeze in margins. Canadian banks with U.S. footprints will be particularly vulnerable to higher regulation. There is also risk that deposits will become scarcer in Canada due to the spillover effect of the negative global banking headlines, and banks will have to become more cautious in their lending due to a slowdown in capital inflows.
Impact on interest rates
As a result of the regional banking crisis, interest rates have moved quite a bit lower from their peak in early March, as the market believes central bankers may soon pause and wait to see how the tightening credit conditions will impact the economy. However, if inflation doesn’t follow suit and drop quickly, the market will recalibrate, and rates will move higher again.
The equity market has very much decoupled from the bond market in recent months. Interest rates are lower because the bond market is forecasting an economic downturn, while equities are shrugging that off and trading firmly.
As such, investors should consider that the stock market isn’t properly pricing in the risk to future earnings due to tighter credit conditions and increased banking regulations. With small and mid-sized banks accounting for a significant portion of commercial, industrial and residential real estate lending, they are undeniably an important engine for economic growth.
That’s why the macroeconomic impact is highly uncertain now despite the apparent stability post the regional banking rescue effort.
A disciplined approach
Despite this uncertainty, financial advisors can take this opportunity to reassure their clients that policy-makers in Canada have effective tools in place to manage a crisis such as that experienced by the regional banking sector in the U.S.
This will in turn help clients maintain the discipline to keep their portfolios aligned with their objectives, time horizon and risk tolerance. Volatility in performance or a decline in an asset class can often lead investors to sell at lows or buy at highs, but that is often a result of the emotional reaction to unrealized losses.
Keeping these factors in mind, a disciplined investment approach will undoubtably lead to better outcomes in the long run.
Lesley Marks is chief investment officer of equities with Mackenzie Investments.