Why do banking crises happen every so often?

And with the debacle of Credit Suisse and the takeover of the bank by UBS, the question arises as to why banking crises keep occurring time and again.

The real product of a bank is trust: When I deposit money in my bank account, I trust the bank to pay it back to me when I want to dispose of it. That should be obvious, but it is not.

Why?

Because the banks use the money entrusted to them to finance mortgages, consumer loans to private individuals or business loans to companies. Or they buy securities through their clients' money deposits. The latter was the undoing of Silicon Valley Bank (SVB) because it had purchased supposedly safe American government bonds. But SVB did not hedge against rising interest rates, so its securities portfolio lost value after the interest rate hikes of the US Federal Reserve (FED).

As a side note: Why bonds lose value when interest rates rise, and not the other way around, is explained here and illustrated with our bond price calculator.

Well, interest rate hikes are not a problem per se as long as customers do not demand their money faster than expected. But as soon as withdrawals by bank customers start gathering pace, word gets around and becomes like an avalanche: The dreaded bank run occurs.

As has now happened at Credit Suisse. The bank then has to sell its silverware, i.e. securities, mostly bonds. If it subsequently has to realise losses on such sales due to increased interest rates, for example, this further erodes the trust of its clientele. It is similar with asset management clients. If they withdraw, this is not a problem for the bank’s balance sheet, but the income continues to dwindle and the big bank cannot match its cost base to a smaller business model fast enough.

Then there is nothing left but liquidation, nationalisation or takeover by a competitor. In the latter case, the Swiss government and the National Bank had to provide guarantees so that the takeover of Credit Suisse by UBS could take place at all.

It is interesting to note that ten years after the 60-billion rescue of UBS by the state and the National Bank, Switzerland voted in 2018 on a popular initiative that would have obliged banks to hold one franc at the Swiss National Bank (SNB) for every franc of client deposits, so that money creation would be the sole responsibility of the National Bank and banking crises would be avoided. The full money initiative was rejected by three quarters of the voters and by all cantons. Whether a full money system is the solution to all problems remains to be seen.

But to put it in a nutshell: If I keep my money in a bank account, the bank invests and lends out my money in one way or another, from which risks arise for me as an account holder or as a taxpayer, while the profits go to the bank. That is the classic business model of the bank. This business model is profitable for the bank, since risks and opportunities for returns are distributed asymmetrically, in favour of the bank.

Those who do not want to participate in this and can handle the risk of loss can also invest their money directly on the capital market themselves. This exposes your capital to the daily fluctuations of the stock markets. But at least you get a risk premium in the long run (see also: Drawdown: How much can you afford to lose?).

At True Wealth, we make this as easy as possible for you. We use ETFs for our client portfolios (read more about the advantages of these investment instruments here; our Pillar 3a investment solution also uses index funds in addition to ETFs). These investment instruments, ETF and index funds, are not held by us, but are kept in a securities custody account in your name at our custodian banks. The difference to cash deposits: They are not included in the bank balance sheet, but are treated as special assets. This means that even in the event of bankruptcy of the custodian bank, your securities will never fall into the bankruptcy estate of the bank, but remain your property.

Banking crises, like other market shocks, are difficult to predict, which is why we ensure diversification in our client portfolios and invest passively (read more here: Invest Passively: Because Stock Picking Is a Matter of Luck).

From an investor's point of view, however, banking crises and market upheavals also have their good side: The lower the stock market valuation, the more shares you get for every franc of money invested. This applies to money already invested (because our rebalancing automatically switches to the asset class that has lost value), but also to newly invested money.

But here, too, market timing is extremely difficult; even professionals find it hard to predict the right time to enter the market. Successful investing requires one thing: Serenity and a long-term view.