Will the US banking crisis reach Irish shores?

Fifteen years to the week after the collapse of Wall Street bank Bear Stearns prompted global investors to pounce on Irish banking stocks – triggering what would be dubbed as the St Patrick’s Day massacre – as they hunted for other weak spots, a fresh US banking crisis is raising questions about whether it could end up on Irish shores.

After all, as much €4 billion has been wiped off the combined market value of the three remaining banks, AIB, Bank of Ireland and Permanent TSB (PTSB), as part of a sell-off of the sector since Thursday morning, when it became clear that California-based Silicon Valley Bank (SVB), a lender focused on start-ups, was in trouble.

Still, banking stocks globally staged a rally from their lows on Tuesday, with US banking stocks, measured by the KBW Nasdaq Bank Index, rising almost 5 per cent in early trading on Wall Street, following a 21 per cent slump by sector over the three previous sessions. European banks, including Irish lenders, also staged a rebound on Tuesday from their lows.

So, what caused the collapse of Silicon Valley Bank?

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While banks typically make more money in the rising interest rate environment we’ve seen over the past year – where the US Federal Reserve and European Central Bank have increased rates by 4.5 percentage points and 3 points respectively – SVB’s net profits fell 15 per cent last year as it took valuation losses on certain investments and more than tripled the amount of provisions set aside to cover potential loan losses.

SVB warned in its latest annual report that its non-performing loans (NPLs) can be volatile due to its focus on early-stage and mid-stage start-up technology, life science and healthcare companies. Loan repayments in this area often depend on borrowers getting more finance from venture capital investors or the sales of the companies involved.

“Conditions in the US economy have caused certain client valuations to drop, thereby reducing the rate of financing or other ‘exit’ events for certain clients, which has had, and may continue to have, an adverse effect on certain of our clients and their ability to repay their loans to us,” it said.

[ Chris Horn: Did ‘winner takes all’ culture of tech industry lead to Silicon Valley Bank’s fall? ]

But the real crunch point came last Wednesday when SVB sold a $21 billion (€19.7 billion) bond investment portfolio to fund customer deposit withdrawals. SVB made a $1.8 billion loss on the disposal, even though the portfolio was mainly low-risk US government bonds, rather than the toxic sub-prime mortgage backed securities that banks had loaded up before the 2008 crisis.

The SVB loss was due to the average market interest rate, or yield, on the portfolio being less than half the prevailing 3.9 per cent rate on 10-year US Government bonds.

Bond values move in the opposite direction to bond yields. The deal underscored how banks’ balance sheets can be exposed to soaring interest rates if they do not have sufficient rate hedges on their bond portfolios. SVB had let virtually all of its rate hedges expire last year, at a time when most banks globally – including Irish lenders – increased hedging.

As SVB made a failed attempted last week to sell shares to raise capital to shore up its finances, prominent venture capitalists that invest in start-ups openly advised companies to pull deposits they had in SVB, prompting a run on the bank.

The Federal Deposit Insurance Corporation (FDIC) moved early on Friday to close the lender.

But haven’t there been other US bank failures in the past decade? What makes this one different?

Indeed, there have been 71 US bank failures in the past decade, including four in 2020, according to FDIC. However, SVB, with over $200 billion of assets, is the biggest implosion since 2008.

What made this one really different is the fact that it is a big lender to tech start-ups. And the real concern was around the deposits these firms had in the bank. Depositors in US banks are covered by a FDIC guarantee of up to $250,000 in any one company.

A big bullet was dodged over the weekend as the US Government took the extraordinary step of guaranteeing SVB’s deposits as well as those of New York-based Signature Bank, a big property lender that had recently developed deep ties with the cryptocurrency industry, which the FDIC seized on Sunday.

SVB’s UK arm was taken over by HSBC early on Monday in a deal overseen by the Bank of England. Most of the bank’s Irish clients, estimated to be close to 100, had deposits and loans with the UK unit.

Why have banking stocks remained under pressure this week?

While US president Joe Biden insisted on Monday that the US banking system remains safe, fears of contagion have resulted in depositors in many US regional banks moving their money into the country’s large “too-big-to-fail” banks. The stress has been captured in share price movements, with San Francisco-based First Republic Bank falling as much as 79 per cent on Monday and Arizona’s Western Alliance Bancorp sliding 85 per cent.

And, as we’ve seen, Irish and other European banking stocks have not been immune, even though they staged a rally from their lows on Tuesday.

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What’s the risk for Irish banks?

Certainly, Irish banks are in a different place from where 2008, when they were heavily exposed to property development lending as the real-estate market collapsed, triggering €64 billion of taxpayer bailouts as lenders’ loan losses spiralled.

While Irish banks loan books continue to be dominated by mortgages, home lending since 2015 has take place under strict Central Bank limits. To a man, each of the chief executives of the three Irish banks said in recent weeks that they have not yet seen any signs of fresh distress in the mortgage books as a result of the cost-of-living crisis. Still, Irish banks have been behind European peers in passing on ECB rate hikes.

At the start of the 2008 crisis, Irish banks started off with low levels of deposits relative to loans, before being subject to a silent bank run as mainly companies, rather than households, pulled billions of euros of savings. This time round, Irish banks have way more deposits than they know what to do with.

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While euro zone banks have €86 on loan for every €100 they hold on deposit, according to Morgan Stanley, AIB had a loan-to-deposit ratio of 58 per cent at the end of December, forcing it to place €37.6 billion of excess cash with central banks. Bank of Ireland had a ratio of 73 per cent and €36.4 billion of surplus cash stored with central banks.

Morgan Stanley estimates Irish banks have only passed on 6 per cent of recent central bank rate hikes to depositors, compared to the European average of 14 per cent and US rate of 23 per cent. This has allowed Irish banks to profit more from rising official deposit rates as they also lag behind peers in passing on increases to mortgage holders.

There is likely to be pressure, as a result of the US crisis, on banks globally to pay up more for deposits than they might have been expecting even a few weeks ago. Irish banks will hardly be immune.

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Irish banks are widely seen by analysts as among the biggest euro zone beneficiaries from rising central bank rates, as interest income accounts for greater portion of their earnings. Indeed, this had fuelled an almost doubling of the market value of Irish banks in 12 months to the middle of last week.

But while it financial markets were betting only a week ago that the ECB would increase its key deposit rate, currently at 2.5 per cent, to a peak of than 4 per cent in its fight against inflation, such expectations have collapsed in recent days.

[ Collapsed Silicon Valley Bank had ‘many’ Irish customers, says McGrath ]

Markets now expect the rate to top out at 3.25-3.5 per cent. It will be difficult, however, for the ECB to back away from a clearly signalled half-point increase on Thursday, for fear that might spook the market into thinking that there is a risk of a systemic failure in the European banking system, according to analysts.

Are there any other concerns?

That’s the big one. There is little doubt, according to many economists, that the events over the past week have heightened the risk of a US recession, which would have big consequences globally – not least for a small, open economy like the Republic.

Jim Reid, an investment strategist with Deutsche Bank, told clients on Tuesday that he is now “even more convinced” of his long-held view that world’s largest economy is in for a “hard landing” in the second half of this year.