Weekly Report
Artem Karida
Educator | C-suite advisor | business strategy, innovation, and marketing expert
Week 13. March 27 - April 2, 2023
INDEX
Macroeconomic indicators
Analytics
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Macroeconomic indicators
Someone will say: “Hurrah! Inflation will start to decrease!”, but this is not the case. In a period of structural crisis, the growth of inflation, in many respects, is like an increase in costs (maintaining a distorted structure of the economy costs more and more). This growth is not monetary; you cannot liquidate it by reducing the money supply.
Moreover, since the decline in the money supply reduces the investment process, cost-push inflation rises, and the rate increase causes an even greater increase in the structural component of inflation. So, most likely, such slow growth in the money supply (much lower than even official inflation) means an intensification of degradation processes in the economy;
Analytics
Credit risk is rising in the US banking system
Credit risk is rising in the US banking system. According to the FDIC,?the cost of creating provisions for credit possible losses/write-offs increased to $ 20.7 billion in Q4 2022, the highest level in absolute terms since Q1 2011 (excluding the one-time effect of the COVID crisis).?This is the period when the deferred effect of the 2009 financial crisis persisted, as did the low quality of the loan portfolio at the time.
Concerning the COVID crisis, banks created 115 billion in reserves in the first and second quarters of 2020, which is four times the norm in 2019 - in many ways, these were preventive measures based on the assumption of an economic collapse, which did not occur, and even the degradation of the loan portfolio did not happen.
Then, in 2020, the Ministry of Finance, the Fed, and the government guaranteed loans to backbone enterprises, credit holidays were implemented, and a slew of other measures was implemented to avert the crisis's acute phase. As a result, for the first time in their history, banks were dissolving reserves totalling 31 billion rubles throughout 2021.
In 2022, the cost of creating provisions for credit write-offs is increasing every quarter and has reached 11.5% in relation to interest income - a 10-year high but still within the normal range.
Actual loan write-offs for the quarter totaled 0.06% of the loan portfolio, which is half the average for 2012-2019 and 13-14 times lower than the peak of the 2008-2009 crisis. While loan quality is average.
The increase in loan provisioning costs is due to the loan portfolio's rapid growth over the last two years (plus 13%), as well as the critically low allocations to reserves from Q3 2020 to Q3 2022 (only $2.7 billion) compared to the norm of $120 billion during this period.
The main point is that?the decline in credit quality in commercial and consumer loans began against a backdrop of rising interest rates.
Because the process has only just begun (banks kept loan rates low due to a cheap funding base and excess liquidity),?credit risk will manifest itself in 2023.
The cost of funding the US banking system is meagre
According to calculations based on primary FDIC statistics,?the cost of funding the US banking system is meagre - only 0.95% per year of?the weighted average cost in accordance with interest expenses on dollar deposits located in US jurisdiction (foreign offices of US banks are not taken into account).
The weighted average rate on dollar deposits was 0.51% in Q3 2022, 0.19% in Q2 2022, and 0.11% at the start of 2022.
It is critical. Deposits form 90% of the total funding resource (liabilities) of the US banking system and determine, in fact, the entire profile of banks in terms of interest expenses.
The weighted average cost of dollar liquidity, on the other hand, was 4.19% in Q4 2022,?2.8% in Q3 2022, 1.1% in Q2 2022, and 0.3% in Q1 2022.
It is a composite index based on interbank loans, funding directly from the Fed, and three-month US bills. This is a complete market rate, i.e. how much are dollars on the interbank market?
Yes, deposit rates are rising, but slowly. As a result, the gap between the market rate and the weighted average rate on deposits is 3.24 percentage points, which is the largest gap in the entire modern history of the US banking system.
This is due to surplus liquidity, which is concentrated in major banks, but this factor is steadily diminishing.
Weighted average lending rates, on the other hand, rose sharply to 5.7% from 4.3% at the start of 2022?(rebounded from the historical low) - the growth rate is significant, but much slower than the Fed rate growth, and current lending rates are in line with the period 2017-2018 when the Fed rate was 2.5%.
As a result, the spread between the market dollar rate and the credit rate shrank to 1.5 percentage points, the smallest for the whole statistical period. The typical spread is 4-4.5 p.p.
The Fed's monetary policy transmission mechanism has been destroyed, and banks are holding lending rates as best they can, but they are rising, affecting borrowers' solvency and actualizing credit risk.
Bank interest margins increased the most in ten years
Bank interest margins increased to 4.8%, the most in ten years.
In general, an increase in the interest margin with an increase in the Central Bank's key rate is unusual due to the transient nature of assets and liabilities, with deposits being mostly short-term and assets (loans) being predominantly medium-term and long-term (concerning mortgage loans).
All true, but not in the "new normal" age.?Because of the excess bank liquidity generated over the last 13-15 years of monetary frenzy, large banks have been able to raise deposit rates at a slower rate than the current cost of dollar liquidity.
A market-only, pragmatic approach. There is no sense in attracting and/or retaining clients if there is extra cash. This was in 2021 and the first half of 2022, but deposits have been actively declining since mid-2022, which is naturally reflected in the money supply decline.
At the same time,?deposits in the second half of 2022 decreased primarily at large banks,?while deposits at small and medium-sized banks stagnated and only collapsed in March.
This is because wealthy and large clients prefer large banks, while regional banks have concentrated deposits from the proletariat.
Rich clients began to redistribute deposits in real estate (luxury real estate has better price dynamics than mass real estate), stocks, and bonds in search of higher yields.
Deposits began to be transferred to large banks again in March as a result of the failure of regional and local banks.
All of this implies that interest rate risk will rise when excess liquidity is exhausted, cash gaps widen, and deposit rates rise to attract and/or keep customers.
Furthermore,?these processes will be disjointed. Megabanks may maintain high margins, while small and medium-sized banks will face challenges (liquidity depletion, depositor flight, competition for clients/investors -> deposit rate rise).
First Citizens inherits the bankrupt SVB
First Citizens inherits the bankrupt SVB, which had over 200 billion assets (173 billion deposits) at the start of the year and 167 billion assets at the time of bankruptcy (119 billion deposits).
As a result, media conjecture of a large-scale flight of savings and investors was validated by official FDIC information.
SVB lost one-third of its deposit base in a matter of months, and bankruptcy was unavoidable owing to technical reasons. To meet consumer demands, the bank sold assets, resulting in losses that surpassed capital.
First Citizens receives 52 billion in deposits and 72 billion in assets at a $16.5 billion discount, while sharing the FDIC's asset disposal losses.
Securities worth $90 billion have been surrendered to the FDIC, and the FDIC has lost approximately $20 billion in deposit insurance.
There may be an expectation that the banking crisis will pass, but the history of financial crises reveals that these processes can last for years.
Given the recent high-intensity incidents, it is evident that financial institution disruption cannot occur on a regular basis in hot headlines with online updates.
It is critical to underline that the banking crisis (which is actually a broader and more accurate phrase for a financial crisis) will not end until tight financial conditions, notably high interest rates, normalize.
Damaging activities in the financial system can act as a trigger and catalyst for a slew of bad processes affecting a diverse range of economic actors and spreading to all links in the chain.
It is critical to clearly describe the financial system's profile and potential weaknesses. The financial system's disposition will be monitored as long as the other flanks remain largely steady.
About the financial system's response to rising interest rates...
A dramatic increase in the Fed's rate results in the realization of interest rate risk in the US banking system, or, to put it another way, a sharp drop in bank interest margins. This occurs when the growth rate of interest expense on obligations begins to exceed the growth rate of interest revenue on assets.
First and foremost, due to the time structure of assets and liabilities. Loan revenue has an inertial characteristic due to the characteristics of the loan portfolio.
Many of the mortgage loans in their portfolio, for example, are long-term (15 or 30 years) and fixed-rate, and this loan portfolio was built during a 13-year era of low rates from 2009 to 2022.
Deposits, on the other hand, are largely short-term and rotate more quickly in line with current market rates.
True, there were times when banks were uninterested in recruiting a deposit base, allowing them to dramatically diverge deposit rates from money market rates, but this is no longer the case.
As a result,?competition for a depositor, and investors, and an increase in rates are unavoidable?(interest expenses will rise), especially in light of the banking system's fragmentation, as the deposit base is transferred from small and medium-sized banks to large ones.
Bank margins will be reduced as a result of these activities. To compensate for these processes, banks will be obliged to boost loan interest rates, which will, on the one hand, dampen demand for new loans while also reducing borrowers' stability as part of refinancing current loans under new terms.
This would result in an increase in delinquencies and write-offs (the realization of credit risk), which will dramatically raise the cost of generating provisions for loan losses at low margins (on the medium-term track), further damaging bank stability.
As a result, market and interest rate risk (losses on securities as rates rise and net interest margins fall) - > credit risk (increase in the cost of credit losses) - > bank losses - > fresh bankruptcies and cash shortfalls. It's only the beginning!
Bonds are purchased by Americans
In 2022, American consumers will channel an unprecedented amount of funds into bonds - more than 1.5 trillion each year - with a considerable portion (more than 1 trillion) allocated in treasuries, functioning as the primary buyer, countering the Fed's and non-residents' exodus.
In monetary terms, this is a historical high, and in terms of household income, it represents 8.3% of total annual income from all sources?(salary, business, interest, dividends, social, pension and insurance payments). A stronger flow occurred at the start of 2009 when more than 10% of the proceeds were distributed into bonds.
When the general population in the United States purchases bonds, two factors come into play: the financial/economic crisis (from 2008 to 2010) and the rate disparity between bonds and deposits (2018-2019 and 2022).
Much has been written about the interest rate differential between deposits and bonds. This is the reason for the decrease in the deposit base and the national money supply, although exact figures are required.
In Q4 2022, the populace withdrew 365 billion from deposits - an absolute record, an enormous flight from monetary assets with no precedent in history. There was an influx during the inflationary crisis of the 1970s and 1980s.
The public is already withdrawing money in the second quarter (in Q3 2022 minus 42 billion). Before it, there was a record influx of 4.3 trillion due to government helicopter money from Q2 2020 to Q2 2022. (4 times higher than the norm for the comparable period).
The current alignment is not surprising, but the size is intriguing.?Concurrently with the flight from deposits, there is a flight from stocks, where the annual flow has declined to minus 1% compared to earnings?after retail clients' extraordinary interest in shares in 2020-2021 (to 6.5% of earnings). The share sale was completed in the third quarter, and there was a modest inflow after the year.
Hence, the US population supports the debt market's stability in the face of negative real rates and Fed sales, and the sale of shares and withdrawal of funds from deposits acts as a resource.
Bonds vs. stocks
The interest rate gap between financial instruments, combined with macroeconomic uncertainty, is the key to rising demand for bonds.
There can be no substantial demand for both stocks and bonds at the same time, which confirms the history of cash flows. Peak liquidity distribution in shares has always been connected with record outflows in bonds and vice versa.
Hence, sustainable development in the equity market cannot be achieved until the debt market's difficulties are rectified and natural demand returns to normal - conditions in which interest rates are positive in real terms.
There are no other sufficiently capacious and liquid points for capital investment in conditions of inflation, when deposits give less than 1%, and shares in a period of uncertainty and degradation of the operating performance of businesses and banks can "zero out" at any time ", as it was "with success stories" in 2022.
In 2022, a significant event occurred: for the first time since the 1930s, cash flow to deposits and equities became negative at the same time, while the situation with deposits worsens by the quarter, while the balance point for equities was found in Q4 2022.
Deposits will continue to flow out as long as the interest rate differential between deposits and bonds remains. As a result of the uneven distribution of bank reserves and deposits, the banking system becomes unstable.
Big banks have a surplus, whereas small and medium-sized banks have a shortfall, forcing them to raise rates more quickly, realizing the interest rate first and subsequently the credit risk.
Bank excess liquidity contributed to the debt market's stability in 2022 (low deposit rates -> outflow to bonds), but it may destabilize the situation in 2023 due to liquidity distortions within the banking system and the need to raise deposit rates.
Public company capitalization (worldwide)
Global public company capitalization (excluding GDRs/ADRs) is approximately $102 trillion (based on data from national exchanges and TradingView).
Only two countries control around 56% of global capitalization: the United States ($42 trillion) and China ($15 trillion).
If Western states (the Anglo-Saxon globe) occupied almost all (except China) the TOP 20 top countries by capitalization in 2008, newcomers "penetrated" there in 2023:
When we examine the shares of Western countries between 2000 and 2008, we can see the artificial fragmentation of the world order, and, more crucially, the trend over the last 25 years (almost):
Emerging countries that are generally independent/detached from the Anglo-Saxon world are fast-growing, and the focus of growth is shifting away from the United States and Europe and toward Asia.
West's estimated share:
China and India are the primary drivers, with China being the most significant contributor, with its financial system expanding more than tenfold (!) since 2008.
Russia accounts for over half of global capitalization and has experienced the greatest losses in dollar terms since 2008 among all major countries - more than half for peers and more than a third for the market capitalization (many new companies have listed during this time).
Market capitalization is not a universal indicator of economic progress, but it does reveal the depth and capacity of a country's financial system. The capitalization of enterprises in the national dimension is influenced by industry structure, financial system capacity, the range and diversification of financial structures, non-resident participation, market confidence, and the quality of growth of legal and corporate institutional units.
What factors influence stock market capitalization?
(without regard to order)
In light of the composition of risk factors and the structure of the market, economy, and political system in the context of contemporary difficulties and problems, thinking about the high or low cost of a particular market is counterproductive.
Russia has nearly finished repaying its foreign debt
External debt fell by more than $100 billion over the year (down 21% year on year from $482 to $380 billion). Only in 2015 did a more extensive drop occur (-24% y/y).
External debt has nearly halved from reaching a high in 2014 ($733 billion). Before mid-2007, the current level of external debt was decreasing.
This is the longest and most significant drop in external liabilities in modern history for any large country.
Foreign debt to GDP fell to 17% in 2013, 34% in 2014, 40-42% in 2016 due to the depreciation of the ruble, and 25-27% 20 years ago.
The external debt-to-GDP ratio has fallen to its lowest level since at least 2000.
There are also encouraging signs. In the early 2000s, about 100% of external debt was in foreign currency; by 2005, this had dropped to 90%, 77% in 2008, 75% in 2014, 72% in 2021, and currently 65-67%.
By the start of 2022, foreign currency debt was almost entirely distributed in dollars (59%), euros (28%), and other currencies (13%), with "unfavourable/unfriendly for Russia" currencies accounting for about 95%.
The debt's currency structure is still unknown, but there is no doubt that the share of "unfriendly" currencies would drop owing to technical reasons - entirely shut external funding sources in these currencies.
At the very least, the drop in external liabilities will follow the trajectory of debt repayment when the circulation period finishes, although early payback is also acceptable (in 2022, they paid off $102 billion with a debt of up to a year of $86 billion).
The Russian financial system is rapidly displacing the Western financial system, and there are two considerations that all Western economists must bear in mind:
The amount of Fed credit programs
Since mid-March, the amount of Fed credit programs in favour of the financial system has declined somewhat from $415 billion to $398 billion, while the banking system rescue program has decreased from $400 billion to $383 billion.
REPO operations reduced from 60 billion to 50 billion, discount window loans decreased from 110 billion to 88 billion, the FDIC support program stayed at 180 billion, and the new BTFP program secured by securities valued at par climbed from 54 to 64 billion.
The banking system's hole is projected to be $400 billion, and this volume was picked up, but this was only the first blow - a trial one, and there are still many troubles ahead.
The problem with the Fed's lending programs is that they are excessively expensive - 5% per year in dollars, which is exorbitant; in fact, no short-term instruments can afford such costs. In this respect, unlike QE, it is not worth waiting for this money to come into the market, and banks will want to unload the Fed's assistance as soon as feasible.
The Fed entirely failed to meet its commitments to reduce its balance sheet in March. Instead of $95 billion, the balance sheet was decreased by $23 billion, leaving a total gap of $255 billion, or over three months of labour, between the announced plan and the dumped securities.
Yet, bank liquidity has increased even further. Banks have 400 billion greater deposits with the Fed than at the beginning of March (3.4 trillion versus 3 trillion) and yet have surplus liquidity within the dollar REPO - plus 130 billion (an increase from 2.1 to 2.27 trillion). In a single month, the US Treasury poured about $200 billion into the economy to finance the budget deficit.
As a result, the US Treasury now has only 163 billion in cash on its balance sheet, but there was a surplus in April, so they may last until June if no more bankruptcies occur.
Because the FDIC is insolvent, any subsequent bankruptcies are entirely at the expense of the printing press and/or taxpayers via government expenditure -u003e deficit growth.
They are basically on the verge. The national debt limit will be lifted in June, and we will soon have to actively borrow, which may cause problems.
The US money supply
The US money supply is contracting at an alarming rate. In nominal terms, the 2.3% drop is the largest since 1937, while in real terms, the drop is 7.8%. This data predates the banking crisis.
In April 1980, the anti-record was negative at 6.5%, and in December 1974, it was minus 5.9%.
The last time there was a sharper decline was in 1946-1947 (minus 12%) during the post-war contraction of money circulation, which grew by 18-20% in real terms over four years, i.e. this was a technical moment because previously the growth of the money supply corresponded with the growth of output in the economy.
During the Great Depression, the real money supply declined by 10-11% at the time. There is every probability that the historical anti-records will be updated in 2023.
What came before the current events?
From March 2020 to February 2022, the nominal money supply increased by $6.3 trillion, or 42%, on the trajectory of "helicopter money" from the Treasury and the Fed's monetary frenzy, whereas the usual growth rate is an annual increment of $650-$750 billion.
M2 growth exceeded normalized growth by more than four times, indicating that the economy can digest the "money overhang."
These events resulted in excessive consumption and inflation, both monetary and structural.
The second major mechanism is the divergence of deposit rates from bond rates (explained in detail before),
which pulls liquidity out of mutual funds and, in particular, money market funds (a record influx in history! ), which in turn overwhelmingly invest in bonds.
Even with the current decline, the nominal money supply diverges from the 10-year trend by 20% (current $21.1 versus $17.5 trillion), while the real money supply diverges by no less than 7%.
Historically, liquidity contraction crises always return the money supply to 10-year trends and then change into a negative deviation for at least 3-4 years, indicating that there is still a protracted phase of contraction ahead.
The debt market's disposition is extremely risky
Money market rates are currently about 5%. Short-term treasuries with maturities of up to a year are quoted at 4.7 to 4.9%, whereas short-term highly dependable corporate bonds of class A and above are quoted at 4.7 to 6.5%, depending on the issuer. Class "B," and especially "C," is a different discussion.
The majority of market demand is now focused on:
The expenses of high-interest rates are gradually and on a large scale passed on to issuers, and there are also supply issues.
There are currently $58.7 trillion in bonds in circulation, of which $54.9 trillion are issued by national governments and $49.5 trillion by the non-financial sector ($18.7 trillion are in the private non-financial sector and $30.8 trillion by the public sector).
In 2023, approximately $12 trillion will be spent on refinancing without taking into account the increase in debt at extremely high rates and still attempting to place. Municipal and corporate bonds at par fell last year! Only treasuries and MBS saw consistent debt increase.
There are risks in the non-financial industry as well as the banking sector.
The banking crisis. It's merely the beginning
Small and medium-sized bank runs in the United States have temporarily ceased - there was a slight inflow in the week of March 15-22, within the accuracy of the account ($6 billion), following an all-time outflow of nearly $200 billion in the week of March 8-15, while large banks (TOP 25) attracted $67 billion.
Nonetheless, the deposit base continues to dwindle, with large banks losing $90 billion in the most recent reporting week. As a result, large banks lost $23 billion over the two weeks of the banking crisis, while small and medium-sized banks cut deposits by $190 billion, for a total of minus $213 billion excluding regional offices of international banks.
Between January 1, 2023, and March 22, 2023, American banks cut their deposit base by $420 billion, with the majority of the decline (almost half) occurring in the last two weeks of March.
The deposit high ($16.9 trillion for US banks) occurred on March 9, 2022, a week before the Fed began raising interest rates. The faster the Fed raises interest rates, the wider the spread between deposit rates and competitive assets in bonds gets. This resulted in a natural flight away from deposits.
The banking crisis occurred exactly one year after the exodus began.
Deposits declined by $450 billion in almost 10 months of 2022 from the peak's formation (March 9 - December 31), and another $420 billion at the start of 2023, implying that outflow rates increased rapidly, roughly three times. $1 trillion could be exchanged by the beginning of May.
Although the deposit base has increased by about $5 trillion from the height of COVID-19 to the peak of March, the flight from deposits is destabilizing the banking sector.
Alternative funding channels (interbank + Fed operations) are in high demand, particularly among small and medium-sized banks, which have begun to borrow more than giant banks for the first time in history while having half the assets.
Alternative funding channels from small and medium-sized banks absorbed over 12% of liabilities (the highest since November 2009), while large banks took -7.8% (the highest since March 2020).
The banking crisis is not ended; rather, it is just getting started. The wave zero has passed.
THE END OF THE REPORT
Stay tuned.?
Regards, Negorbis.
The key info about the financial and banking crisis can be found in three issues dedicated to this subject:
Part I "Falling Bank Chronicles"
Part II "Crisis of confidence & regionalization"
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