Dawn of the Dead: Decoding Zombie Banks and Bailouts

The fiasco around the Silicon Valley Bank (SVB) has got the whole world to question numerous things, from the start-up culture existing and thriving in the US to being overly pessimistic about the financial system. A couple of months back, nobody really knew about SVB, and suddenly, it's everywhere due to its shenanigans. This brings us to another question, "Do Zombie Banks still exist?". I'm not saying that SVB was this bank with negative equity value throughout; although this was the case late, it is a practice or an existing convention that must be considered. Banks work differently and cannot be looked at and valued like any other company. There are a ton of different practices that take place at a bank, something that might be uncommon to other businesses. Banks work differently, whether it's the direct impact of interest rates on the financial institutions' Net Interest Margins (NIM) or the practice of manipulating the fair value of their assets and liabilities. The recent acquisition of the First Republic Bank by JP Morgan is not helping in clearing the air around America's banking crisis. Let's look into zombie banks and the primary reasons for these banks collapsing, and why bailouts are so prevalent in financial institutions. 

BRING BACK THE DEAD

A "Zombie Bank" is a banking financial institution with an economic net worth of less than zero but continues to operate because its ability to repay its debts is shored up by implicit or explicit government credit support. These institutions are solvent, despite being insolvent due to how they hide their Non-Performing Assets (NPA). The world has seen numerous examples of this. When considering a significant financial crisis, zombie banks are essential to ruining a delectable economy. 

Back in 1990, Japan became the hub for zombie banks because of the crisis that was going on in the capital and real estate markets. Japan was experiencing a weird time in the late 1980s' when the Yen appreciated due to multiple events, and the Bank of Japan failed to recognize the urgency of the matter. A recession was on the cards, and the deck did tumble, but the appreciation also drove in heaps of investment, especially in real estate and equities. Nikkei and land prices surged, and due to some actions, the central bank took, the recession was taken care of. The Yen kept strengthening and reached all-time highs against the US dollar, making the capital markets soar like anything else. Even after the introduction of the consumption tax in 1989 and the increased interest rates, the markets didn't stop rising, but the land prices crashed. When the housing prices and investments were surging in Japan, banks did deploy a lot of money in mortgages, which all came crashing down subsequently, and as a result, bank credit growth stagnated. The financial institutions were bailed out through capital infusions from the government, loans, and cheap credit from the central bank. The ability to postpone the recognition of losses ultimately turned them into zombie banks. 

Europe and the US are also no different and are considered hubs for zombie banks, even though the balance sheets might not reflect that. The 2008 subprime mortgage crisis has been the most dreadful financial crisis the past few generations have seen. Nothing has brought the financial world to such a halt, barring the pandemic. The enormity and the gargantuan amount of unethical activities that were taking place concerning Mortgage Backed Securities (MBS) and their securitization into CDOs' and its many variants came like a bolt out of the blue. Forget the United States; even Europe collapsed like anything as they held many of these instruments and swaps on those. After 2008, many banks in the US and Europe are believed to be zombie banks and are often alleged to be dependent on the central bank for liquidity. Let's not even get to the point where European states had to be bailed out with the help of the European Union and IMF. Supposedly, over 114 European banks were bailed out with the help of government emergency programs, most of which can be specifically attributed to the financial crisis in the US. Even the US announced a $700 billion bailout fund for many banking institutions. Maybe we should call the whole crisis an "Apocalypse" instead of whatever was said.

ARE WE BACK IN 2008?

Things really started to fall when the Silicon Valley bank went under. At the core of it, it was eventually about risk management and how SVB was managing and prioritizing the right mix of assets when it came to holding mortgage-backed securities, direct loans, and liquid assets. Initially, they had a small equity cushion of just 5.6% of their assets, which is relatively low compared to other banks in the US and Canada, where the average usually hovers around 12%. Things took a turn when the Fed raised rates, and all the long-term assets that were explicitly dealing with variable interests started depreciating significantly. The bank had massive unrealized losses and attempted to cover them by selling some of its assets. Another issue was that the assets were sold at a loss, and the investors' outlook started deteriorating. The final nail in the coffin was when most venture capital firms and early-stage ventures started pulling out their deposits, signaling that the country should be prepared for a catastrophe. Whether it was really that serious or a ripple effect that took place is a monumental question. However, it cannot be denied that SVB was still at massive fault when managing risk and adopting meaningful disclosure. The inopportune fall of First Republic Bank didn't come as a surprise. The bank found itself troubled by the Fed's move to curb inflation by increasing interest rates aggressively, and yet again, it all came down to risk management. The bank had billions in exposure to interest rate-sensitive securities and was over-relying on non-FDIC-insured deposits, making them a textbook target for regional bank failure. First Republic had invested heavily in long-term assets, including mortgage-backed securities, and invested in government securities when the rates were low. When the interest rates increased by nearly five percentage points, the assets lost their value and the yields you might earn now on these instruments. Logically, the interest rates that they had to pay on their deposits had to increase, and the increased income on First Republic's assets was not enough to cover the losses that arose due to the fall in prices of the government securities and the fall in the value of the long term mortgage-backed securities and other loans. The failure of SVB and Signature Bank proved to be a complimenting factor during the decline of First Republic, and yet again, the depositors simply pulled out. The shares went tumbling and lost close to 96% of their value, And the $30 billion infusion from some of the major banks in EU S didn't help either. It had to be taken over by FDIC and is now sold to JP Morgan with several associated terms, including the FDIC agreeing to reimburse JP Morgan for a large portion of the losses incurred on the acquired loans and providing $50 billion in five years, fixed-rate financing. 

The current banking crisis diverges markedly from the 2008 financial crisis in several significant aspects, underscoring their dissimilarity. Firstly, the genesis of the 2008 crisis was primarily rooted in the collapse of the subprime mortgage market in the United States, propelled by unsafe lending practices, securitization of mortgage loans, and excessive leveraging within the financial system. Conversely, the present crisis lacks a singular precipitating event, exhibiting a more complex and multifaceted character, with an amalgamation of factors contributing to its emergence. The crisis in 2008 was over a different scale altogether. It involved a tremendous amount and scale of debt securitization, making it a crisis in the US and worldwide. The problem in the current scenario is not about bad loans or securities with multiple levels of complex tranches; it has more to do with how risk management pans out and why some of the traditional banks were not maintaining an optimal ratio when it came to safer and relatively in volatile assets, compared to the long term and volatile ones. a lot of it also has to do with the current economic scenario, before the crisis unfolded in 2008, the economy was doing just fine, and people were optimistic about the possibility of growing at a healthy rate, especially after coming out of the dot com crisis. In the past three years, however, the global economy almost seems to be in some shackles, and people worldwide have been conservative and pessimistic in their approach, especially regarding capital markets. All this played out when the banks mentioned above were not doing as well as they would have done in a robust economy. Still, much of it also had to do with people panicking, leading to a ripple effect across the country's banking sector. The scale of the disaster in 2008 was humungous compared to now, and it involved some of the major financial institutions worldwide, including Bear Sterns, Lehmann Brothers, and AIG. It was more about a continuous effect created around the global economy and how a single instrument amplified its effect, which proved catastrophic. Bailouts also became a part of the conversation when the $800 billion Troubled Asset Relief Program (TARP) was announced, something which might or might not be needed at the given time but could be unsuccessful and highly controversial given the modern times. 

CONCLUDING REMARKS

Whether the stepping in of FDIC or other government bodies or bailouts being announced to rescue these banks is a possibility, and a positive thing remains undecided. An ordinary person walking on the street, hearing all of this, would be amused and in perpetual fear and shock. It won't be because of how things would pan out or consider what will happen to my money; it will be a simple thought "Is Capitalism Deaf and Dumb?". It is not like the World has not seen such an economic condition or a constant urge to increase the rates, but why are the failures still taking place? Don't these banks learn from past situations and the caveats that keep hovering around, or is it simply about being ignorant. It raises another question about the Federal Reserve and whether they can expect transparency. What about regulating these banks and keeping a close eye on the deposits and the asset mix? What about proper disclosure concerning unrealized losses on the sale of these assets? I guess it will still be a question unanswered, and we will learn as they say.