Wall Street is rediscovering the cockroach theory about banking crises. No wonder this metaphor is so popular in New York, where bugs compete with rats for dominance of territory. The theory is this. If a cockroach shows up in your kitchen sink or on the bathroom floor and you manage to kill it, don’t kid yourself, even if you do manage to murder the intruder, the animal isn’t a solitary species. Expect some of his siblings, sons, and cousins to show up soon. The first cockroach is the vanguard of an invasion, usually because these cockroaches live in families, tribes, colonies. The cockroach theory has been used for various types of crises, most notably bank crashes. Even ailing banks are often part of a herd, not isolated cases. This is how 2008 worked. Will 2023 likely repeat the same pattern?
The roach theory does not mean that the world will succumb to an invasion of these bugs. However, it invites us to take the overly reassuring claims with some skepticism and caution. One of them all: “That can’t happen here.” It’s a movie we’ve seen before. In 2008, Europeans initially said the crisis was purely American, linked to the excesses of a certain type of financial capitalism. Then the euro zone slipped into the tunnel of an even longer and more painful turbulence than the American one.
In 2023, many said at the beginning: The Silicon Valley Bank is related to the tech bubble, that’s a completely Californian story. Then a New York bank went bust. Then they heard: the usual Americans… “but Europe is much healthier and more solid, there is nothing to fear on the old continent”. Credit Suisse soon blew up, forcing the Swiss central bank to lend 100 billion in liquidity and UBS to intervene with an emergency takeover. “But Switzerland is not part of the eurozone,” someone stressed to reassure the impossibility of contagion. In fact, the security criteria for capital and bank deposits in Switzerland reflect the standards of the ECB. However the Swiss cockroach may have a German cousin, it is Deutsche Bank that is rocking the markets today. I can already hear the new reassurances, such as: Deutsche Bank has always been a “black sheep”, highly controversial for years.
The chant is always the same: “This can’t happen here.” It is understandable that banking authorities and regulators need to use this type of language. To do this, they would only have to sow doubt and thus become alarmists themselves. But in the meantime, the cockroaches keep coming out of the sink. And there is also the justified suspicion that the supervisory authorities are using reassuring words to cover up their own mistakes: a year ago, for example, the Federal Reserve examined the Silicon Valley Bank for obvious irregularities. What are those checks for if the bank is going down anyway?
Meanwhile, the aftershocks are not over in the USA either. Among the feared medium-sized banks, another one has been added with PacWest. One fact stands out above all. Since the Federal Reserve activated two new special branches to lend money to banks on March 12, lenders have been drawing on these loans at an interest rate of $117 billion every night. In calm times, this type of credit did not reach 10 billion. In America, too, controversy lingers over Treasury Secretary Janet Yellen’s decision to bail out all customers of failed banks, which goes far beyond the insurance guarantee that covers deposits up to $250,000. Saving the very rich was necessary, according to Yellen, to stop the contagion of panic, to prevent the savers’ flight from spreading to other…cockroaches. But bailout of the very rich, in addition to ethical and political doubts, prevents the market economy from cleaning up by punishing those who made wrong and inefficient decisions. Not all banks are cockroaches, and very wealthy customers should be able to exercise discretion and transfer their money to the best-run institutions, rewarding efficiency.
One cannot help feeling that the initial US Treasury and Fed bailouts are evidence that “the ceiling is too short”. We have long lived in a world awash in cheap credit with zero interest rates. Too many borrowed easily because lenders and investors failed to make the right choices. The interest rate hike is causing confusion in many places. What we see at work in the banking system is a simple, mundane, mechanical mechanism. Even without speculative and risky investments, those banks that in the golden years filled their bellies with low-yielding fixed-rate government bonds and didn’t buy instruments to hedge against the risk of rising interest rates now have virtual losses that are gigantic (from $620 billion to threefold, according to the estimates circulating for the American banking system alone). When investor flight forces these banks to sell securities, the losses become real.
But the end of the credit-friendly era, the onset of inflation and the associated rise in interest rates will reveal hidden weaknesses in many other areas. Big Tech’s bubble was one of the first to burst. The real estate market is another highly exposed sector. And then there’s the whole wide world we don’t see: the Great Global South. I recently met with World Bank President David Malpass here in New York. Here’s what the man who is basically the biggest lender to emerging markets says: “The worst shock that rate hikes give is the one that hits poor countries. There was also a period of easy lending to emerging markets, now the backlash is coming. This will become all the more difficult as the rich countries will absorb a large part of global capital over the next few years just to service their growing national debt.” The list of national bankruptcies is getting longer, from South America to Africa to Asia. When an entire nation collapses, we are less shocked than a western bank crash because our savings are not directly affected. That doesn’t mean we won’t be affected in other ways.