What Has Happened in the Banking Sector?
After the events of the last few weeks in the banking sector, it begs the question as to whether there is a common underlying theme, or are these just outliers? Banking stocks are now down after what had been a relatively buoy-ish 30% run from January 2023. As of March 20, at least five entities have undergone some level of surgery, most of which has been quite invasive. Whilst the treatments were broadly the same, namely capital intervention, the underlying causes were vastly different. However, what we see as a common motivator are the consequences of failing to act, imprinted on many of us from the heat of the 2008 banking crisis.
The prospect of the near-death experience of a classic bank run on deposits caused the regulators to move swiftly and curtail the fallout, having seen the impact of failing to act before. It also appears monetary tightening has been an aggravating factor, impacting asset valuations, as well as the cost of capital. We have been trading in an era of essentially free money for the last 15 years, but COVID-19 and events in Europe gave the central bankers the excuses they needed to reset interest rates as a policy lever, for some, the financial equivalent of the tide going out.
However complex banks or fintechs look from the outside, their operating principles are relatively straightforward. Assets, risk weighted, or otherwise, ought to be worth at least the same or greater than liabilities, namely the deposits. If there is a problem, word gets out, deposits get pulled, only serving to worsen the situation. This is where mark-to-market, the proper operation of three lines of defense and stress testing, are investors’ best friends. Undoubtedly, these will be areas of focus for another chapter in the history of banking failures of our times describing dealing with March 2023.
What About the Customers?
Every sympathy should be extended to any of the customers who were in any way disrupted or distracted by all that’s happened. Having worked in startups and big corporates, every cent is precious; money comes in, and money goes out, and you check your balances daily, if not more. Not being able to pay counterparties, suppliers, or your staff, kills trust, and trust is binary. Once lost, it is difficult to restore. Money issues are also incredibly stressful and hugely distracting. Enormous credit is due to the various competent authorities for what seemed like the seamless process of moving these different entities into the next chapter of their existence. Many of the people involved have seen this kind of thing before, most likely extending as far back as Bank of Credit and Commerce International (BCCI) in 1991. Of note, this bank failure resulted in the liquidators, Deloitte & Touche pursuing Price Waterhouse (now part of PricewaterhouseCoopers) and Ernst & Whinney (now Ernst & Young) who audited BCCI, for a range of alleged failings, albeit subsequently settling some seven years after the original claims were launched. Bank failures are a messy, expensive and lengthy business, and they need to be avoided at all costs. The ideal is for banking services to be spread across three or four different deposit takers. This shares the capped protection of the different deposit insurance schemes across different banks. However, securing multiple bank accounts is harder than it sounds, especially for startups and crypto entities.
Is the Market in Banking Services Operating Properly?
Probably, but certain customer segments are most likely not being serviced properly. For the last 10 years or so, I have been involved in digital asset businesses, startups and fintechs helping them grow or solve issues. In almost every conversation, the subject of banking services inevitably arises and, invariably, there are only ever three of four potential suitors. Against this backdrop, it is reasonable to question the level of competition for banking services that results in many businesses being left with no other choice than to bank with one or two players. It is fair to say, most financial services players are suspicious and questioning of anything to do with digital assets, and while fintechs attract lower risk premia, none of this can be good. Having businesses, whether fintech or crypto, work through circuitous routes to secure bank accounts, risks compromising financial hygiene; this does little to foster the development of a hugely important segment in the economy. The risk profile of money, and particularly crypto, its related entities and the individuals behind it can be measured, and therefore decisions made as to whether services can be offered. This profile changes over time, allowing services to be withdrawn or advanced. Everyone interested in competition should be asking themselves, what can we do to help create an effective market for banking services that reduces concentration risk.
What About the Regulators?
Regulation is difficult. It is a point of data concentration within the financial services ecosystem, where all the different risks being run by regulated entities need to be understood, modelled and forecast. Regulators require a vast range of skills, and as public sector entities, it can be difficult to attract the right talent. At the most basic level, the supporting technology is about spreadsheets, email, macros and call centers. At the most sophisticated level, it’s about highly skilled supervisors working with the leadership of the regulated entity to develop a good understanding of how the risk profile changes with time. Ensuring that the right capital adequacy and liquidity provisions have been made and showing how they are tied to the proper risk weighting of assets, is essential. This changes over time, and with questionable IT, poor risk management and rotating staff, the quality of the risk metrics degrade. It is easy to read the numbers, but one must understand how good that number is and the related data. All of this then needs to be underpinned by the auditors, one of the other shareholders’ backstops.
What About the Future?
Properly operating capital markets and the creation of credit, counter-balanced by a vital environmental, social and governance (ESG) agenda, are essential for economic prosperity. The type of money, fiat, crypto or central bank and even asset class are somewhat secondary relative to the challenge of the underlying data. Whatever the business, whether a bank, telecommunications provider or crypto exchange, its viability and financial hygiene is a function of the numbers. Real time, transparency and diversity of risk modelling is essential, and while many of us are turning our attention to ponder the impact of ChatGPT, it’s somewhat irrelevant if basic risks cannot be modelled. Given the events of the last few weeks, the warning signs had to be there. We must ask ourselves whether our data is doing its job in a risk context to detect, prevent and resolve events, the fallout from which takes time and money to fix.