Banking Central | Why Uday Kotak was spot on in warning on Credit Suisse

Very few banks qualify for the distinction of a global systemically important bank. Only about 30 of them are in that league, including Bank of China, Bank of America and JP Morgan Chase. In simple words, these are institutions that are too big and interconnected with rest of the financial system where a failure could be catastrophic.

Credit Suisse was one such lender that failed over the weekend and got acquired in a Swiss-government brokered deal for shade above $3 billion, or a 60 percent discount to its share price. Credit Suisse was valued at $8.7 billion at a closing price of 1.86 Swiss francs on Friday.

But the bank, with a balance sheet of $575 billion, didn’t have a choice. It was running out of options over the weekend that left it with only the UBS deal or a potential takeover by the Swiss government. Why did Credit Suisse fail? It isn’t just a follow-on effect of the US banking crisis. The crisis at Credit Suisse was brewing for many years due to repeated scandals, loss of business and senior level exits.

The scandals involved letting clients evade taxes, partying to accounting fraud, high-risk bets and so on. What has happened now is fall of a weak bank with faulty governance and business model.

Now, what does this deal mean for global banks? To start with, this deal has averted a big-scale banking crisis at this point. Last week, we saw the Silicon Valley Bank (SVB) failure that was followed by two other banks in the US.

A Credit Suisse failure would have been much more catastrophic to the world compared with SVB due to its sheer size and interconnectedness. SVB wasn’t even half of the size of Credit Suisse in assets.

Does this mean that the banking crisis over now? Unlikely.

There are a number of banks in the US that are staring at a similar situation as SVB, which necessitates immediate liquidity support in the event of failures. That’s the reason the US government is talking to big investors like Warren Buffet to invest in small banks. Over the next few days, clarity will emerge on the stability of the US banking system which will determine the course of the current round of banking crisis.

Liquidity rush

In the meantime, a bigger challenge awaits. Over the weekend, a clutch of major central banks announced coordinated action to ease liquidity constraints by launching a line of dollar swaps to ensure liquidity availability if the banking crisis deepens.

The effort, led by US Fed, would increase the frequency of so-called swap lines, which provide access to US dollar funding, from weekly to daily, with the European Central Bank, the Bank of Japan, the Bank of England, the Bank of Canada and the Swiss National Bank.

One another unfortunate fallout of the Credit Suisse collapse is the write-down of a massive $17 billion additional tier 1 (AT1) bonds. Investors will not get anything out of this written down portfolio. In India, too, a similar episode had played out when Yes Bank wrote off around Rs 8,400 crores worth AT1 bonds during its 2020 bailout.

On Monday, veteran banker Uday Kotak tweeted saying that the hurried sale, at a 60 percent discount to Friday’s closing price, and the $ 17 billion AT1 bond write-off is a signal of the perils when the risk-return matrix is overtaken by obsession with size.

Kotak is absolutely bang on here. A failure of risk assessment over size caused the bank’s downfall and hit investors badly.

What is the major lesson for India from the global developments? Although not comparable, the reasons for failure of SVB-like smaller banks in the US and Credit Suisse stem from poor risk management and weak governance. In the case of SVB, the interest-rate risks and concentration risk (when majority of the money was parked in similar securities) were ignored while in the case of Credit Suisse, good governance was given a miss by engaging in unethical practices as exposed over the years.

Are Indian banks at risk too?

Indian banks have improved significantly in terms of capital adequacy and the risk management over the last few years, thanks to a watchful central bank. A merciless asset quality review that exposed hidden dirt under the carpets of banks and subsequent tightening of prudential regulations (on exposure, capital etc) have made Indian banks much safer bets compared with the risky western banks.

Yet, there are persisting risks. There is too much concentration on retail books in recent years with banks increasingly finding this as a safe haven after the debacle on wholesale books in yesteryears. In the event of a global recession, which seems a increased possibility now, could upset calculations. Massive job losses and income erosion could delay repayments.

Similarly, a resurgence of inflation around the world could backfire on India, too. The liquidity rush announced by the US and European central banks will mean higher inflationary risks ahead and even steeper rate hikes to contain price rise. Soaring yields could put banks at the risk of mark-to-market losses, even though in India, unlike western banks, the exposure to bonds are much less. Higher interest rates could derail the feeble economic recovery.

Third, there are clear risks of sentiment. Failure of banks elsewhere will typically lead to a flight to safety of money. Smaller banks in India too may face issues when depositors take money to bigger banks.

To avoid this, a higher deposit insurance cover is necessary as I argued in an earlier column.

A few years ago, in an interview with this author, former RBI deputy governor, late KC Chakravarty had argued that Indian banks have poor risk management systems making these entities vulnerable to frauds. Bank have come a long way since that point but can’t ignore important cues emerging from global events.

Banking Central is a weekly column that keeps a close watch and connects the dots about the sector's most important events for readers.