After a very rocky few weeks, peak panic among customers and investors alike about the health of the world’s banks seems to have eased. The key question now is whether it was a warning of wider systemic woes across the financial system or whether it was just a passing storm. On balance, we think it was probably neither. Instead, it seems likely to prove another painful step towards a broad global economic slowdown later this year. 

When interest rates rise forcefully and rapidly – and the rate-hiking cycle in the US has been the most aggressive since the early 1980s – strains nearly always show up somewhere in the financial system. This time, casualties have been three US regional banks, which all failed in early March prompting government-led bailouts of depositors for two of them, and the forced takeover of Swiss banking giant Credit Suisse.

What went wrong?

The biggest of the US banks to collapse was California’s Silicon Valley Bank (SVB). Its demise was because its assets didn’t match its liabilities. It had invested lot of its deposits in long-term government bonds, but it didn’t hedge them adequately against rising interest rates. The value of these bonds fell steeply as rates have risen, meaning it didn’t have enough assets to meet its liabilities when its customers wanted their money back.

Credit Suisse then found itself in the eye of the storm. It was way larger than SVB and deemed systemically important to the global banking system. It had gained an unfortunate reputation as the sick man among Europe’s biggest banks over the last few years after a series of big losses and scandals. And its profitability has been exceptionally poor. 

Given peak investor jitters about banking’s next weakest link, investors in Credit Suisse soon scrambled to sell its shares and bonds as its customers pulled money out of the bank in droves. Switzerland’s central bank and regulators stepped in and forced Credit Suisse’s larger rival UBS to take it over 

In truth, SVB and Credit Suisse had precious little in common given the big differences in their balance sheets, liquidity (cash available) buffers and business models. What they did share was that their managements each made some big miscalculations. And in today’s hyper-connected world, their customers and investors’ loss of confidence in them spread like wildfire on social media. No one has to queue up to get their money out of a bank anymore. Digital banking means we can move our money in seconds. All this triggered liquidity problems at these banks very, very quickly. SVB’s customers, for example, pulled a staggering $42 billion (£34.1billion) in deposits out – a quarter of the total – of the bank in a day in what’s been described as the first-ever Twitter-led bank run. 

Policymakers have stepped in quickly and effectively to ease the strains on the banking sector. The largest banks globally are much better capitalised now than they were ahead of the Global Financial Crisis (GFC) back in 2008, giving them much greater capacity to absorb losses. Their liquidity – the cash they have on hand – is also much stronger. In addition, we don’t see evidence of widespread risky lending to borrowers with poor credit quality, as was the case before the GFC. 

So a GFC-like systemic financial crisis that might put bank depositors at risk feels very unlikely. But, equally, it seems clear that all the legislation and support from governments and central banks in the world can’t guarantee a crisis-proof banking system. 

Bank runs aren’t necessarily driven by rational analysis of cold hard facts. Instead, they’re triggered by sentiment, rumours and behavioural psychology (if in doubt, follow the herd). Almost anything has the potential to trigger a panic if enough people get spooked at the same time. 

The natural response to all this is that banks seem likely to do their utmost to look as conservative and reliable as they can. Lenders around the world are likely to turn more cautious. Banks started tightening their lending standards significantly late last year. That trend is now likely to intensify further, making it tougher for households and businesses to borrow.

This raises the (already significant) risk of a global economic recession. In turn, this reinforces our focus on high-quality businesses whose profits are less susceptible to ups and downs in the wider economy. These companies tend to keep on making steady sales even when businesses and households are hurting. They sell the products and services that people can’t do without. 

Tune in to The Sharpe End — a multi-asset investing podcast from Rathbones. You can listen here or wherever you get your podcasts. New episodes monthly.