By FERNANDO NOGUEIRA DA COSTA*
Could bankruptcy turn into a systemic risk, that is, a global banking crisis?
“Bankruptcy”, financial ruin, is a word imported by Portuguese in the XNUMXth century from Italian. bank rotta, literally: broken bank. It expresses the situation when a person, company or country cannot pay its debts and goes into financial collapse.
When a bank goes bankrupt, it is usually declared bankrupt and all its assets are sold to pay off outstanding debts. It is considered a last resort and is often preceded by unsuccessful attempts to restructure debt or renegotiate loan terms.
The biggest bank failure in the United States since the Great Financial Crisis (GCF) of 2008 occurred on March 10, 2023, when Silicon Valley Bank (SVB) was taken into receivership. Around 92,5% of their deposits were unsecured, equivalent to the FGC (Brazilian Credit Guarantee Fund), leading to significant withdrawals from them and resulting in the bank collapsing within two days.
The Federal Reserve Bank responded to high imported inflation and the post-pandemic rise in unit labor costs by continually increasing the reference interest rate, thereby causing a substantial drop in the market value of long-term assets. From March 07, 2022 to March 6, 2023, the federal funds rate rose sharply from 0,08% to 4,57%, an increase accompanied by a quantitative tightening of the money supply.
As a consequence, long-term assets similar to those held on bank balance sheets suffered significant declines in value during the same period. For example, the trading fund representing the market value of home mortgages declined approximately 11% over the reporting period.
The market value of commercial mortgages fell 10%. Long-term Treasuries were particularly hard hit by monetary policy tightening, with the 10-20-year and 20+-year Treasuries losing around 25% and 30% of their market value, respectively.
Losses on the assets of approximately 4.800 US banks exclude their held-to-maturity loan portfolios so as not to be marked to market. Includes real estate-linked securities (mortgage-backed), US Treasuries and other asset-backed securities (type LCI/LCA in Brazil).
These assets comprise 80% of $20 trillion in bank assets, according to Jiang, Matvos, Piskorski and Seru, university professors and researchers at NBER. Adjusting these assets of the US banking system to their current market values indicates that they are $2 trillion less than suggested by their book value.
Surprisingly, Silicon Valley Bank was not as outstanding in the distribution of marked-to-market losses, with about 10% of banks reporting the worst losses in their portfolios. Evaluating bank funding structures, prior to the recent monetary tightening, Silicon Valley Bank was reasonably well capitalized from a financial leverage standpoint, with 10% of banks having less capital than Silicon Valley Bank, however, it stood out with use of unsecured deposits.
Silicon Valley Bank was ranked in the 1st percentile of the distribution in unsecured leverage, suggesting over 78% of its assets were funded by unsecured deposits. Therefore, Silicon Valley Bank's bank liabilities were more prone to runs on withdrawals compared to those of other banks.
The lay reader in banking finance, at this point, must understand this technical jargon to understand whether this bankruptcy could turn into a systemic risk, that is, a banking crisis on a global level. I will try to briefly explain this proposition of the cited co-authors: “unsecured leverage (ie, unsecured debt/assets) is the key to understanding whether these losses will lead to the insolvency of some banks in the United States. Unlike insured depositors, uninsured depositors can lose a portion of their deposits if the bank fails, potentially giving them incentives for a bank run.”
The first concept to be aware of is that of financial leverage: the use of debt to increase a company's or individual's return on investment. Allows you to invest in more profitable assets rather than possible with your own capital. However, if the investments are not successful, the company may find it difficult to pay the financial expenses and pay the debt.
Another key concept to understand is “mark-to-market” (Mark-to-Market or MtM): the daily update of the price of an asset. With it, the investor has the closest notion of the security's real value and can take advantage of opportunities before maturity. As it is a constant adjustment, fluctuations in this price occur downwards or upwards, as a reflection of the economic scenario, altered by the crucial decision to set interest rates.
To perform MtM, it is necessary to obtain the updated market prices for each financial asset that needs to be valued. In order to determine the fair market value of assets and liabilities, market analysts, price quotations on the stock exchange, the evaluation of models by ANBIMA specialists, etc. contribute.
Both public debt securities and private credit securities such as CRAs, CRIs and debentures are marked-to-market. As a result, even portfolios of DI Investment Funds (post-fixed) may see a drop in the value of their shares when The Market is “sold” on these securities in the secondary market, that is, the bet on a fall in the market value of the shares predominates. bonds already issued. MtM does not change the yield contracted to maturity, however, it informs the price of the asset if the depositor redeems it in advance, which may or may not be positive.
As for insured depositors, since the 90s, due to the growing concern of the authorities with the stability of the financial system, deposit guarantee systems began to appear formally. It has become a real world trend.
In Brazil, in August 1995, a resolution of the National Monetary Council (CMN) authorized the “constitution of a private, non-profit entity, destined to manage protection mechanisms for holders of credits against financial institutions”. In November of the same year, the Fundo Garantidor de Créditos (FGC) was born, a civil association with a legal personality governed by private law. In addition to being a “debt payer”, appearing on the scene in bankruptcies, the FGC has professionals prepared to act preventively throughout the banking and financial system.
Here, the maximum amount of each individual (CPF) or legal entity (CNPJ), against all associated institutions of the same financial conglomerate was guaranteed up to the amount of R$ 250.000,00, as of May 2013, for banking products such as the various deposits and bills. Other credits are not covered by the ordinary guarantee, such as those from open private pension entities, insurance companies, capitalization companies, investment clubs and investment funds.
The case study of the recently bankrupt Silicon Valley Bank (SVB) is illustrative. Nearly 10% of banks had larger unrecognized losses compared to Silicon Valley Bank. Silicon Valley Bank was also not the worst capitalized bank, with 10% of banks having a lower capitalization than it.
However, Silicon Valley Bank had a disproportionate share of uninsured leverage: only 1% of banks had more. Combined, the market value losses of its MtM assets and uninsured leverage, i.e., carried by unsecured deposits – in the US at $250 – encouraged a rush by uninsured depositors to preemptive withdrawals. before bankruptcy.
Worse, systemic risk is multiplied if unsecured deposit withdrawals cause even small short-term sales of long-term assets to maturity. With the consequent further drop in their market value, substantially more banks will be at risk.
In summary, when central banks tighten monetary policy, it can have significant negative impacts on the value of long-term assets, including government bonds and mortgages, and generate losses for banks. They usually carry out maturity transformation: they finance long-term assets with higher interest rates by raising short-term liabilities such as deposits with expected lower interest rates.
If baseline interest rates rise, it lowers the value of long assets and makes it more expensive to raise liabilities, potentially leading to bank failure through two broad but related channels. First, if liabilities exceed the value of its assets, it could become insolvent. Second, if uninsured depositors become worried about possible losses and rush to withdraw their funds. The demonstration effect contaminates the others – hence the bankruptcy.
*Fernando Nogueira da Costa He is a full professor at the Institute of Economics at Unicamp. Author, among other books, of Support and enrichment network (Available here).
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