Chaotic systems can be described in many ways but the one I remember from my youth was dubbed ‘the butterfly effect,’ Loosely put, it describes the phenomenon that the flapping of a butterfly’s wings on one side of the world can dramatically influence the weather on the other side of the world. The idea, pioneered by Lorenz and others, has found widespread application in so called deterministic chaos models.
Deterministic chaos models theorise that very small differences in initial conditions or inputs (for example a butterfly flapping its wings) can provide widely different and unpredictable outcomes in different scenarios (the weather on the other side of the world). Such models are quite different from our linear traditional finance models where a small change in inputs usually generates a small and predictable change in outputs.
I am reminded of all of this today because events on one side of the world have just had a major consequence on the other. The flapping wings was not from a butterfly but a very much larger beast, which is why markets have been, and beneath their now calmer exterior are, so worried.
It is possible that you were surprised to hear that the specialist deposit taker and lender to venture capital firms in so-called Silicon Valley, rather originally named ‘Silicon Valley Bank’ was the 17th largest in the USA. Ironically though, that name will now likely disappear.
You might also be surprised to hear that KPMG apparently gave them a clean(ish) bill of health only weeks before SVB’s collapse, and that, allegedly, Goldman Sachs and Morgan Stanley similarly made positive statements as underwriters about the strength of the Bank’s balance sheet. You might be forgiven for feeling sorry for the CEO of Sweden’s biggest Pension Fund Alecta who is now leaving his role with immediate effect for having apparently believed them.
Short term liquidity issues at banks are often quietly solved by borrowing a little more, but SVB was already borrowed to the hilt. Solvency and liquidity are the ultimate issues in banking and as banks lend to each other, one bank’s problems can easily become another’s, and that is what we have just seen.
Sorting all this out is going to take time, even where there is the will, but the world does not have much time when it comes to questioning the security of our money in the banking system.
We learned about that system in 2008 you will recall, and whilst it is arguably more robust today than it was back then, it remains ‘joined up’ and Credit Suisse is now no more, having been hoovered up by UBS under the direction of the Swiss regulator. Protections are in place today to mean that it is less joined up now than it was back then, but nagging doubts should remain. After all, the system is still ten times levered, not 30, and it still relies on trust, so these events do not help.
Have we seen this playbook before? Bear Stearns was quite a big player that went bust some months before the events of September 2008. That little butterfly, with the benefit of hindsight, was an indicator that we didn’t sufficiently understand at the time. The Rating Agencies had told us everything was fine in the garden back then; and we believed them. I still shudder when thinking of all those red screens, but I thankfully kept my job.
So, can the failure of a major European bank be laid at the feet of the local bankers at SVB for allegedly managing their own affairs poorly? Both traditional and non-linear theories might say so.
The real answer this time is to look to the central bankers, who held interest rates down for so long and then so aggressively raised them without apparently understanding the consequences of either. Being regulators, they jolly well should have done.
SVB and CS are high-profile casualties of their policies, but I fear that the shark that is lurking in the shallows of European banking is still swimming free. If the bankers don’t wake up (or get replaced?) and realise that interest rates cannot go up in a straight line, there will be shark attacks galore, especially in the highly levered real estate and infrastructure markets that rely on the free flow of debt capital to make their existence worthwhile.
A butterfly has flapped its wings. What happens now depends on your view of economic theory and history, and central bankers, and that rather worries me. If we live in a non-linear world of deterministic chaos theory, then your guess is as good as mine what happens next or perhaps more likely, in a few months’ time. And right now, that worries me a whole lot more.
Gold is trading at close to its all-time high’s especially in Sterling. That at least makes a whole lot of sense to me right now.
