Author : Aequitas
On 10th March 2023, Silicon Valley Bank, the 16th largest bank in the USA collapsed, marking the largest bank failure since the 2008 financial crisis. Two days later, on 12th March 2023, Signature Bank closed and was taken into possession by the New York State Authorities. While clouded by the news and aftermath of these two bank collapses, the first bank to collapse was Silvergate who announced voluntary liquidation on 8th March 2023.
Collapse of these three banks created a ripple effect creating liquidity concerns in many banks including First Republic Bank and Credit Suisse. The top US banks came to the rescue of First Republic Bank by providing liquidity support and Credit Suisse was acquired by UBS under the direction of Swiss National Bank on 19th March 2023.
In a matter of 11 days a massive tornado swept the whole banking industry in the United States taking 3 of them in its fold. While this appears to be a one of its kind event, a run on banks causing collapse of banks in a domino effect is not an unprecedented event. Once in a while, at times a long while, we are reminded that in the financial markets, history absolutely does repeat itself and is not to be forgotten so easily. Back in 1907, the US markets faced a similar situation, wherein, in October and November 1907 alone, 25 banks and 17 trusts (akin to shadow banks in current times) had shut shops. This episode later came to be known as the Knickerbocker Crisis or Panic of 1907.
The Knickerbocker Crisis
The earthquake in San Francisco in April 1906 caused massive losses raising claim liabilities for insurance companies then based out of England. The Bank of England, in an effort to curtail flow of funds from the United Kingdom had raised interest rates substantially which was then retaliated with steep interest rates increases in the United States as well. Liquidity crunch that followed pushed the US economy into recession in early 1907.
In this backdrop, two gentlemen, Augustus Heinze and Charles Morse attempted to corner the shares of United Copper Company based on the belief that the Heinze family already controlled the majority of the company and that a large number of shares were sold short. These gentlemen had approached Charles T Barney, then president of Knickerbocker Trust Company to finance cornering of shares, however Barney did not agree for the same. They decided to corner the shares anyway but the scheme failed and they suffered huge losses. The failure of the corner attempt pushed their brokerage house, Gross & Kleeberg into bankruptcy. The State Savings Bank of Butte Montana (owned by Augustus Heinze) announced its insolvency. As news of the collapse spread, depositors rushed to withdraw funds from Mercantile National Bank and other banks, where Heinze and Morse were president or had any associations.
In the early 1900s, trust companies were booming; in the decade before 1907, their assets had grown by 244%. During the same period, national bank assets grew by 97%, while state banks in New York increased by 82%. While a trust operates similarly to a bank in many ways, one key difference is that it is not required to meet the same cash reserve requirements. In the early 1900s, the reserve requirement for trusts was only 5 percent of customer deposits. Trust companies also lent aggressively as compared to traditional banks. Knickerbocker Trust Company was one of the largest trust companies of the time and was known to have association with Heinze and Morse through Barney. Although Barney had refused to finance this corner, there was a run on the Trust that led to its bankruptcy. Panic spread to regional banks and trusts and many state and local banks became insolvent in the process.
Lending to businesses dropped and interest rates for loans to brokers rose to ~70%. Commodity prices plummeted, industrial production dropped and unemployment rate increased. Stock market fell by over 40%. Trust in the financial system – the cornerstone of the banking industry failed completely.
John Pierpont Morgan, 70 at that time, played a pivotal role in quelling the panic and steadily bringing order to the system. To begin with, he raised $3 million along with a couple of his associates to save the Trust Company of America following a depositor run. He also managed to arrange a $25-million pool of funds to lower the skyrocketing interest rates brokerage firms were having to pay to meet their borrowing requirements, thereby avoiding an almost certain stock market crash. He arranged for a deal with all trust-company bankers agreeing to bail out the commercial bankers who were severely struggling with runs on their deposits. He also enabled the sale of Tennessee Coal, Iron and Railroad Company (TCI) to the U.S. Steel Corporation to bail out Moore & Schley, one of the exchange’s largest brokerage houses.
Back to Panic of 2023
One cannot ignore the uncanny resemblance of episodes that occurred over a century apart.
In the last 100 years, the banking system and capital markets have evolved by leaps and bounds and are relatively much more regulated. Despite the progress, rising interest rates, aggressive lending, increasing number of shadow lenders, leveraged speculation, short squeeze, etc. are still biting us the same way it did a century ago. Inflation led to a hike in interest rates created fears of economic slowdown back in 1907 just as it did now. Aggressive lending by shadow banks has fatal consequences irrespective of the era. Several banks and lenders that grew on the back of long stretches of low interest rates became vulnerable when the tide turned. Be it short squeeze in United Copper Company in 1907 or Game Stop in 2021, leveraged speculation driven by greed can be punitive to investors on both sides of the trade. Not to mention, the cascading effect it can have on other market participants.
If anything, with the advancement of technology and regulation in financial markets, the impact of such events has only escalated over the years. While it took a few weeks for the contagion to spread in 1907, SVB bank collapsed within 48 hours of making its press release. In absence of a central banking system back then in 1907, J P Morgan along with his associates had to step in the role that Fed has today and provide much needed liquidity and stability to the banking system. The strategy adopted by the Swiss National Bank to find an acquirer for Credit Suisse probably drew inspiration from the acquisition of TCI by the U.S. Steel.
To conclude, as long as financial markets are driven by humans and have a nexus to investor emotions, psychology – history will keep repeating itself. Greed will create excesses in markets which would be followed by fear at its extremes. Asset Classes, Sectors, investment approach, securities, countries will go in and out of favour, but Cycles are inevitable – as they are the only Constants in markets.