Spiralling financial crisis will lay waste to the real economy

And, just like that, we find ourselves in the midst of a full-blown financial crisis. In two weeks, three US banks have collapsed, Wall Street and the Fed have propped up First Republic Bank, and Credit Suisse – a 167-year-old epitome of solidity with a $600-billion balance sheet – has been fire-sold to erstwhile competitor UBS.

The $3.2-billion rescue package orchestrated by government authorities over the weekend almost completely wiped out shareholders and some bond holders.

Alongside the package is $100-billion in liquidity assistance to UBS from the Swiss National Bank and a $10-billion loss guarantee from the Swiss taxpayer. This is a bailout in everything but name.

Amid the technicalities it is easy to lose sight of the essential flaw of banking. The entire system depends on trust outweighing fear. Deposit holders, faced with this dilemma, can withdraw their cash at will. A bank’s loans are, by definition, not as liquid as overnight deposits. Mass withdrawals, or even the fear of them, can topple any lender.

Bank runs are the financial manifestation of humanity’s tendency, in moments of blind panic, for individuals to prioritise what is personally rational at the expense of what is collectively rational.

This is the prisoner’s dilemma in action. It may be rational for you to pull out uninsured deposits before your bank’s immediate liquidity is exhausted. It is, however, collectively irrational to destroy an institution that benefits everyone.

The first question must be why Credit Suisse? Was there some wisdom to the action of the crowd? Over its history, the Swiss colossus financed Alpine railroads and Silicon Valley, while its private bank managed the fortunes of Arab royals and Russian oligarchs. Its investment bank, after acquiring the legendary firm First Boston, gunned for the giants of Wall Street.

Indeed, it even came through the financial crisis of 2008 relatively better off than its great rival; while UBS needed full-scale intervention, Credit Suisse merely needed capital injections from the Gulf and central bank lines of liquidity.

Buoyed by hubris, management then became determined to build a global champion, combining a best-of-breed Swiss domestic retail bank, one of the world’s largest wealth management businesses and a US investment bank. But it struggled to control risk and consistently make money.

Over the past few years the bank has been plagued with seemingly interminable scandals, errors and humiliating volte-faces.

Astonishingly, these included arranging loans worth $1.3-billion to the Mozambican government, between 2012 and 2016, supposedly to buy fishing boats. A portion of the funds was unaccounted for, with one of Mozambique’s contractors later found to have secretly arranged “significant kickbacks” worth at least $137-million, including $50-million for bankers at Credit Suisse.

Its shares traded in line with other European banks until 2021 when, beset with such blunders, they started to diverge sharply downwards. Private bank clients began withdrawing funds.

Then, after the collapse of Silicon Valley Bank across the Atlantic last week, investors quickly turned their sights on the wounded, unprofitable Swiss behemoth – and made for the exit.

When top shareholder Saudi National Bank told Bloomberg in a spectacular own goal that it would “absolutely not” invest more in the lender, a rout was on.

What now? It is safe to say that other institutions will need rescuing before the dust settles. Wily operators will pick up largely sound businesses on the cheap. The pace of interest rate hikes will have to slow, regardless of what central banks might be saying.

Markets and financial conditions will undoubtedly remain extremely volatile for some time and the situation will get worse before it gets better. The problem is that it is simply impossible to know how much worse.

Turmoil in the banking sector will tighten the credit squeeze in the broader economy already set in motion by interest rate increases. With rates ratcheting up, lenders were expected to become more concerned with shoring up their own finances than providing the loans that enable economies to grow – even without a system-threatening banking crisis.

Now they may well turn off the taps altogether. Central banks have been trying to tap the brakes of the global economy to get inflation under control. An ensuing financial crisis will be equivalent to pulling up a handbrake on the highway, causing a monumental pile-up.

We have been predicting for some time that an interest-rate-induced global slowdown is coming. Now, with the fallout in the financial system being more extreme than could have been predicted, the eventual reckoning in the real economy is likely to be much worse. If you have not already prepared for a global recession, it would be best to start now.