scenarios
The Recent Banking Crisis & The Impact On Fasanara’s Alternative Credit Strategies
Ron Barin, Head of Global Strategy
4 April 2023
Introduction
This note summarizes the many interconnected drivers of the current crisis impacting US banks, the US government and Federal Reserve response, and the likely consequences for credit availability and lending standards. This banking crisis will likely serve to accelerate recent trends we have seen for the small & medium enterprise (SME) sector regarding banks further retrenching from providing financing to this already underserved sector. Fasanara as a leader in non-bank Fintech financing and other non-bank fintech lenders have started the fill this growing gap and non-bank lending is rapidly gaining significant market share.
We expect that these trends will create significant tailwinds for our alternative credit strategies as the more that banks exit servicing the SME sector the more there will be greater demand for the type of non-bank fintech alternative financing that Fasanara provides. Further, we expect to be able to extract a higher premium for the financing that we provide that will enhance the investment returns that we provide to our investors. At the heart of Fasanara’s alternative credit strategies lies facilitating much needed support to SME’s and Consumers, key drivers of global economic activity.
Macro Background
The global economy started to enter a higher inflation regime in the second half of 2021 as an outcome of the prolonged 13-year period of zero/negative interest rates, accommodative liquidity policies (quantitative easing or QE) and outsized fiscal stimulus starting in 2020 in response to pandemic-related dislocations (per the US CBO, the FY 2022 US fiscal deficit was $1.4 trillion and FY 2023 is projected to reach $2.8 trillion). The prolonged zero-rate environment made the lowest risk asset expensive and has led to a host of yield-seeking speculative bubbles as investors were forced to move up the risk curve to generate the required return that low risk assets were unable to provide.
Initially, central banks responded slowly to the large uptick in inflation, calling it transitory in nature. However, starting in March 2022, the Federal Reserve has hiked their policy rates at the fastest pace in the past 40 years with the stated goal of tightening financial conditions to bring inflation down. While the pace of inflation has slowed, inflation remains significantly elevated relative to the pre-2022 trend level. The Fed’s slow policy response has caused a deeply inverted yield curve which puts significant stress on the banking system as their short-term cost of funding is now greater than their potential long-term return. An inverted yield curve has been a historically strong signal of recession and elevates the risk of spread of contagion through the banking sector.
Market Impact
The fast pace of interest rate hikes and the withdrawal of monetary (QE) & fiscal stimulus has started to cause severe stresses in parts of the global financial infrastructure and represent symptoms of an unwinding of various bubbles: the 2022 crypto crash; the 2022 UK gilt pension fund LDI crisis and now the 2023 US banking crisis. The current banking crisis serves to highlight that the banking system is a lot more fragile than it was thought to be prior to the collapse of Silicon Valley Bank (SVB). In effect, the higher interest rate environment and the deposit run has exposed bank asset-liability mismatches. The banking crisis has impacted other markets as well – for example, the 2-year Treasury yield fell by 61 basis points on March 13, which was the largest one-day drop in more than 40 years and represented a 3 sigma move (which should occur once every 50+ million years):
In addition, Euro-zone banks are also at risk as they hold around $3 trillion of sovereign bonds which may set off a doom loop if Euro-zone country rating downgrades occur and require banks to provide additional collateral which will drain liquidity from markets. The recent takeover of Credit Suisse by UBS, given the loss of confidence that Credit Suisse experienced due to large losses associated with the collapse of the investment funds Archegos & Greensill Capital, the unwillingness of Credit Suisse’s largest shareholder – Saudi National Bank – to publicly provide additional support, led to large outflows from its wealth management business, may be just the tip of the iceberg, as Deutsche Bank and some Italian banks are under renewed stress.
Bank Lending Impact | Tightening Money Supply
The credit crunch started in earnest in 2022 – bank lending standards have begun to tighten significantly as interest rates have moved higher and will likely substantially contract further as a result of the current banking crisis. The percentage of banks with tighter standards is on par with typical recession periods. This will make consumer and business credit less available and more costly. According to Federal Reserve Chair, Jerome Powell, the current banking sector crisis is expected to provide a tightening of financial conditions equal to one or two more interest rate hikes:
The potential silver lining is that tighter bank lending standards may lead to a weakening of demand and cause a drop in inflationary pressures as banks’ money creation will decline (in a fiat monetary regime, banks create money via their loan activity). This may cause US money supply to contract further – it has declined on the back of Fed’s quantitative tightening (QT) and the end of the government fiscal stimulus programs. It is interesting to note that every previous decline in US money supply led to a depression or a financial crisis:
US Small Banks Overview
US small banks have a large impact on the real economy. Small banks represent 45% of consumer lending, 50% of commercial & industrial (C&I) lending, 60% of real estate lending and 80% of commercial real estate (CRE) lending. Over the past few years, the multi-national regulatory agencies (IMF, BIS & World Bank) and the Federal Reserve have started to raise concerns about the risk of CRE loans as CRE loans have a floating rate profile and are exposed to higher interest rates. In addition, the remote work trend has increased vacancy rates and lowered demand which has led to a drop in rents which may result in collateral drops and negative equity leading to the potential for significant bank loan write-downs. Banks have an outsized $5 trillion exposure to CRE which represents 25% of all bank loans:
The failure of SVB was related to an unusual set of circumstances driven in large part by a vast influx of deposits after the pandemic from the VC tech-related IPO explosion. SVB’s deposits tripled from 2020 to 2022, climbing from $61 billion at the beginning of 2020 to $189 billion by the end of 2022. In addition, SVB’s deposits were concentrated in tech/biotech VC sponsors and related IPO companies as they had nearly 50% of the venture backed technology and life science firms as clients. SVB would typically require that its venture debt investment companies keep their funds at SVB and VCs also required the companies they funded to keep their cash at SVB. Further, SVB’s loan book was also very concentrated in the VC / IPO sector. SVB’s uninsured deposits represented 95% of their total deposits (Signature Bank had uninsured deposits of 94%).
In essence, SVB, Signature Bank and First Republic Bank were caught in an environment of irrational fear and only banks with a high level of uninsured deposits experienced a bank run – deposits had suddenly become hot money fueled by rumors and market chatter. Banks take in short term deposits and invest these funds in longer term loans or securities which creates the need for good asset/liability management practices. There is little reason to mark-to-market high-quality investments as they naturally roll off when they mature. In a normal environment where there is no risk of a bank run, the loans/investments would be money good.
It is interesting to note that if all banks marked-to-market their investments today, given the spike in interest rates, they would all be insolvent, even the large systemically important banks.
Of note, the Fed has been closely monitoring SVB since 2021, as it found weaknesses in how SVB was handling key risks. SVB’s management had different ways to handle their vast deposit growth. They could (1) keep the deposits in cash which would generate no income in the zero-rate environment detracting from their earnings; (2) invest in high quality securities incurring no credit risk and generating modest income; (3) increase their loan book which would create high credit risk.
SVB opted for (2) investing in high quality securities. However, SVB decided to invest in long duration assets as they were implicitly assuming that interest rates would stay at the zero-rate bound for another 10 years. This investment strategy created a large asset liability duration mismatch as they also assumed their increased deposits were traditional, sticky deposits and therefore had a long duration (c. 7 years). SVB also established a large allocation to mortgage-backed securities where duration extends further as interest rates increase due to convexity effects – investing in high quality long-term Treasuries and MBS allowed banks to obtain favorable accounting treatment (HTM) and avoid marking them to market.
On March 9, 2023, after an unsuccessful capital raise, SVB’s customers withdrew $42 billion in deposits which represented roughly 25% of its overall deposit base. SVB went to the Federal Home Loan Bank (FHLB) requesting a $20 billion loan and then attempted to move $20 billion of collateral to the Fed’s discount window, but these requests were not able to be processed the same day – SVB received the $20 billion the next day, but it was too late as the FDIC seized SVB on March 10th. As it turns out, these lender of last resort backstops were not built for speed. There is also speculation that a number of large banks withheld inter-bank loans from SVB and that the VC community actively sought to convince uninsured SVB customers to move their deposits. It is unfortunate that SVB’s VC customer base did not rally around the bank even though SVB had supported the VC community for over 40 years.
US Federal Reserve | Government Policy Response
US policymakers have responded quickly to the current banking crisis to support depositors in trying to avoid additional bank runs. The US banking system currently has $18 trillion of bank deposits – between Q4 2019 and the Q1 2022 US bank deposits rose by $5.4 trillion. Loan demand has been weak since the 2008 global financial crisis, so only 10-15% of this deposit growth was loaned out, with the balance invested in high quality securities. Given the zero-rate environment, banks needed to take on duration risk and add leverage to generate a return that comes closer to their cost of capital.
The FDIC used its ‘systemic risk exemption’ to fully backstop uninsured deposits for SVB and Signature Bank. It appears thar regulators are assessing if they should provide a full backstop of all uninsured deposits for the entire banking system – Treasury Secretary Yellen has recently backtracked earlier comments on this generating significant market confusion.
The Federal Reserve created a new Bank Term Funding Program (BTFP) which provides liquidity to banks facing large deposit withdrawals. The program allows banks to access funds from the Fed at a ~5% interest rate by pledging government bonds marked at par as collateral. This program is similar to the programs created post the 2008 GFC by the Fed (TARP, etc.) which were designed to eliminate the recognition of mark-to-market losses in the short term with the hope that time would heal all – an extend and pretend, kick the can policy framework.
Banking Crisis Fallout
A sound banking system depends on confidence – it is hard for a bank to survive a loss of confidence even if it has good capital ratios and a strong liquidity position. In the zero-rate environment, banks invested in government and agency securities rather than making loans as demand for credit has been low since the weak recovery from the GFC. Bank lending is likely to decline further as depositors flee to higher yielding money market funds. Banks will need to repair balance sheets and pay higher rates to keep deposits which will result in a further tightening of lending standards, reduce credit growth and will serve to increase the odds of a recession. The risk is that new lending may collapse and many existing loans may not be rolled over. The crisis may also lead to an increase in bank consolidations with bigger banks becoming even bigger.
Depositors now realize that their deposits may be at risk and they are earning a well below market interest rate. Bank depositor confidence has started to erode – if depositors question the solvency of a bank, we will see a significant migration of deposits to large banks or money market funds. This will cause banks’ cost of funding to go up significantly (unless interest rates decline due to a Fed pivot). In addition, more regulations are likely on the way for banks to try to avoid a repeat of the SVB and Signature Bank failures – banks will likely need to increase liquidity by shifting more of the asset pool to shorter term, more liquid assets and issue equity to shore up their HTM balance sheet.Policy makers are essentially caught in a trap as the current deeply inverted yield curve coupled with a highly levered, poorly regulated banking system has led to the sudden banking crisis. Our view is that the way out of this trap is to dis-invert the yield curve via an aggressive easing of monetary policy but which may cause a renewed uptick in inflation and a recession – each new rate hike makes the underlying problem worse since it does not help to dis-invert the yield curve.
Bank Crisis Fallout Will Create Favorable Tailwinds for Fasanara’s Alternative Credit Strategies
Since the 2008 financial crisis, SMEs have struggled to access financing from the banking sector. This has created a growing global trade finance funding gap estimated by the Asian Development Bank to be $2.0 trillion in 2022 representing 10% of global exports. In addition, a 2020 surveyt by the International Chamber of Commerce (ICC) showed that 50% of SME trade finance applications are rejected by global banks.
Banks have reduced lending to SME’s, preferring instead to provide large corporates with credit lines. This stemmed from lender risk aversion and the unfavorable regulatory treatment of risk-capital for SME lending. In addition, as public asset markets moved into bubble territory in the reach for yield, zero-rate environment, capital was misallocated and deployed in asset markets rather than to the real economy, increasing the funding gap to both under-banked SME’s and financially excluded consumers globally. Given the weakening economic environment and higher inflation, this is putting more stress on SME’s who need financing to manage cash flow and working capital to support their business operations and foster growth. Closing this financing gap will also make today’s fragile supply chains more resilient and enable them to recover from shocks more easily.
The fallout from the banking crisis will likely increase the SME trade finance funding gap as more banks exit servicing the SME sector as banks lack the resources to identify and monitor creditworthy SME’s . This will create additional tailwinds for our alternative credit strategies, as there will be greater demand for the type of specialty financing that Fasanara provides. Fasanara is leveraging its position as a market leader in the fintech alternative credit space to reprice its existing transactions at an additional premium to increase the returns of its strategies. This will also allow Fasanara to provide much needed additional support to SME’s and consumers as they are critical to a healthy global economy. In addition, the increased growth in the funding gap creates additional investment capacity in our strategies, as we estimate our investment capacity for our alternative credit strategies will increase to the $10 billion range in 2023 and beyond.
2023 has seen the emergence of an ominous environment of US banks under significant stress while the money supply (M2) is collapsing to levels only seen during depressions or a financial crisis. Fasanara, as a leader in non-bank Fintech, has successfully navigated through zero-rate, Covid and higher inflation environments since its inception 12 years ago. Unlike banks, Fasanara’s business has been structured to be resilient, having long-term capital provided by our investors which is deployed in short duration strategies. Further, Fasanara has been able to quickly adapt its portfolios in response to changes in the macro environment and prudently manage portfolio risk via the short duration and extreme diversification employed in its strategies. Fasanara will continue to expand partnerships with its existing originators and develop new ones to further champion SME and Consumer financing, thereby delivery Real Economy Impact.