[One Month of Bankdemic] ① SVB Betrays Safe Assets... Moral Hazard of CS, Unfair Victim DB

Betrayal of Safe Assets Due to Interest Rate Hikes
SVB Pays the Price for Failing to Follow Diversification Principles
CS Wounds Burst Amid Market Distrust
...DB, Psychological Contagion

Editor's NoteThe global bankdemic (bank + pandemic) that started with the Silicon Valley Bank (SVB) in the United States, brought down Credit Suisse (CS) in Europe, and shook Deutsche Bank is approaching its one-month mark. While the three banks share the common denominator of being caught in the whirlwind of a sudden crisis spreading like an epidemic, each showed different aspects regarding the root causes and responsibilities of the crisis. The betrayal of safe assets amid high interest rates is cited as the fundamental cause of the bankdemic, but inadequate internal controls, the spread of irrational fear, and ultra-fast bank runs through mobile banking also exacerbated the situation. However, the fact that characteristic phenomena such as real-time bank runs and irrational market fears occurred commonly and rapidly brought down the banks left an impression similar to the spread of an epidemic. Although the transmission of the crisis seems to have stopped due to swift responses from various countries, it is still too early to be complacent. Jamie Dimon, CEO of JP Morgan Chase, known as the 'Emperor of Wall Street,' warned in his annual shareholder letter released on the 4th (local time) that the recent banking crisis is not over. It is expected to have repercussions across the economy for years to come.

The three banks at the center of the bankdemic met their downfall for different reasons. Some banks caused the crisis through failed investments in bad assets or moral hazard, while others were driven to the brink of collapse in an instant by rumors, concerns, and fear, showing various forms of crisis.

'Betrayal of Safe Assets' SVB Bankruptcy

[Image source=Reuters Yonhap News]

Regarding SVB, the epicenter of this banking crisis, the financial sector largely views it as a 'scapegoat' of interest rate hikes and analyzes it as a prime example of the 'betrayal of safe assets.' The massive investment in ultra-safe U.S. Treasury bonds backfired as it coincided with rising interest rates. This differs from the 2008 global financial crisis, where the 'fat cats (Wall Street)' caused the crisis through reckless investments in bad assets and moral hazard.

SVB invested heavily in U.S. Treasury bonds, considered safe assets, as deposits surged due to quantitative easing triggered by COVID-19. This was a common investment trend among banks at the time. While domestic deposits in U.S. banks increased by 38% from the end of 2019 to the end of 2021, loans only grew by 7%. Banks had to find other investment avenues. During this period, banks chose U.S. Treasury bonds, with holdings increasing by 53%.

The trigger for bankruptcy being safe assets was largely due to the Federal Reserve's (Fed) aggressive tightening that began last year. Banks did not anticipate the Fed would maintain such aggressive tightening for an extended period. As interest rates rose, the prices of U.S. Treasury bonds held by SVB fell, prompting its major clients?Silicon Valley companies?to start withdrawing funds. Especially when it became known that SVB was selling U.S. Treasury bonds at huge losses to return deposits, a bank run erupted. Bankruptcy followed swiftly. Bloomberg noted, "The collapse of SVB shows that the world's most preferred safe asset is not risk-free," adding, "The Fed historically is not good at changing monetary policy without significant shocks. SVB is Exhibit No. 1."

SVB itself contributed to the crisis by investing funds raised through short-term deposits into long-term bond assets, leaving a maturity mismatch unaddressed. Internally, last year, misjudgments betting on interest rate cuts despite the Fed's tightening and complacent situational awareness were also indirect causes of bankruptcy. Hwang Se-woon, Senior Research Fellow at the Korea Capital Market Institute, evaluated, "From a profit maximization perspective, SVB's asset holding strategy was somewhat rational under the expectation that the 'zero interest rate' policy would continue for a considerable period," adding, "Although it had a fairly stable loan portfolio, the cost of not properly adhering to the diversification principle of not putting all eggs in one basket was enormous."

'Foreseen Crisis' CS… Deutsche Bank Hit by 'Sudden Blow'

The fallout from SVB's bankruptcy spread to Europe. Switzerland's second-largest bank, CS, collapsed. Deutsche Bank's stock price plunged, and its default risk soared. However, in terms of responsibility for the crisis, the situations of the two banks were completely different. While CS brought the crisis upon itself through accumulated moral hazard and investment failures, Deutsche Bank became an innocent victim at the center of turmoil due only to fear of the crisis.

The downfall of CS, which boasted 167 years of history as Europe's top investment bank, is widely seen as the bursting of long-standing festering wounds. The SVB incident merely pulled the trigger. In recent years, CS had triggered market distrust due to money laundering, legal disputes, and investment failures. It suffered a fatal blow from internal whistleblowing that it had managed funds for criminals related to corruption, drug trafficking, and dictatorships for decades. In Bulgaria, it allowed money laundering for drug dealers and was convicted last year. In 2021, it suffered losses of $2.7 billion and $5.5 billion from investments in Greensill Capital and Archegos Capital, respectively. As a result, CS customers began massive deposit withdrawals at the end of last year.

On the other hand, Deutsche Bank had no significant problems with financial soundness or investment portfolio. It became a collateral victim in the market searching for the next target amid bankdemic fears. Deutsche Bank's net profit last year was 5 billion euros, a whopping 159% increase from the previous year, and its liquidity coverage ratio (LCR) was a healthy 142%. Although a significant amount of newly issued capital instruments (AT1 or CoCo bonds) became worthless during the CS sale process and the bank had a high proportion of commercial real estate investments showing signs of collapse, these were not enough to threaten the bank's soundness. German Chancellor Olaf Scholz emphasized, "Deutsche Bank is not CS but a profitable bank."

The International Financial Center analyzed, "Recent market reactions to Deutsche Bank are somewhat irrational from an overseas perspective," adding, "Although there are negative factors such as exposure to commercial real estate and investigations by the U.S. Department of Justice, they are insufficient to explain the price fluctuations." Sarah DeVroey, Global Head of Bonds at U.S. asset management firm Vanguard, evaluated, "It is much closer to 'psychological contagion' rather than the 'true systemic contagion' witnessed during the global financial crisis."