Beyond Bulls & Bears

Perspectives

Quick Thoughts: Banks and the butterfly effect—the global ramifications

Financial market volatility has followed the collapse of Silicon Valley Bank. Stephen Dover, Head of Franklin Templeton Institute, shares his thoughts on possible implications outside the United States.

Most of us have seen the movie Jurassic Park. Not many will remember the scene where Jeff Goldblum explains chaos theory, talking about the “butterfly effect.” Chaos theory deals with unpredictability in complex systems but is often misunderstood. Most people think that a butterfly flaps its wings in the Amazon, and it rains in New York. Ed Lorenz, the “father” of chaos theory, was a meteorologist who was saying that even if we had information about every butterfly in the Amazon, it wouldn’t be useful in making weather forecasts in the United States. There is a link to the market volatility this week, as investors who focus on the detail of each bank failure could miss the larger picture.

The collapse of Silicon Valley Bank (SVB) can be viewed as idiosyncratic or specific to an outlier. However, the impact has arguably been system-wide, as deposits at US banks are now (in all practical terms) guaranteed and regulatory supervision of smaller, regional banks will probably increase significantly.

Runs on banks happen regularly, but this time recent events have sent reverberations across financial markets. In Europe and in Asia, banking sector risks from the fallout are very limited, but nervousness in financial markets has emerged to trigger more volatility in the equities and fixed income markets. Here are some observations from outside of the United States:

  • Banking, like investment, is about confidence. Although we all understand that our deposits are (mostly) guaranteed, it is hard to decide not to withdraw your cash when you’re concerned. This is why regulators have acted fast and dealt with these concerns comprehensively. This episode underlines the need for trusted institutions and for regulatory oversight, both of which are appreciated by international investors. That is a global phenomenon.
  • Nervousness in international capital markets seems to be centered around potential repercussions on policy direction of central banks and the US Federal Reserve. Will they feel obliged to pause their policy of raising rates to tame inflation? We think that is unlikely, although we may see a change of pace or magnitude for a time.
  • Recent events might strengthen the arguments against looser regulations. Until a week ago, there were strident voices in the United States and the United Kingdom demanding looser regulation in the name of competition. We should expect increased regulation and oversight globally. Some of that new regulation may have the effect of slowing growth, raising the cost of funding for banks and the cost of doing business for entrepreneurs. A price worth paying, in the view of those depositors who were made whole last weekend.
  • Marketable securities will have to be considered riskier than we had thought. Liquidity in accounting terms comes in many varieties, some of which are not cash at all, and while depositors don’t usually think very hard about the balance sheet strength of the bank they choose, from an investor’s standpoint, it appears that this is exactly the sort of depth of due diligence that is required to avoid surprises. At times when rates are rising, US Treasury Bills may be safe, but they do not keep pace and that can erode liquidity. That is a global phenomenon.
  • Concentration risk is something investors and businesses learned a lot about through the pandemic lockdowns. The reaction has been to diversify supply chains in all goods. The same principle applies to commercial banking. Company managements should diversify their banking relationships for similar reasons—another global phenomenon.
  • The startup-company niche clientele of SVB must rethink its approach to banking relationships, driven by the more traditional and less flexible practices. Logically, this should mean that venture capital or private equity firms could offer parallel services to their early-stage portfolio firms. Private debt firms could be part of this move. Perhaps the biggest impact will be that the big, established technology firms end up dominating the startup space thanks to their strong balance sheets and understanding of the niche.
  • Nervousness in the market has led to the questioning of Credit Suisse and its ability to survive the challenges ahead. The background is of a big bank that has had poor risk management for some years and is in the process of becoming smaller. The bank’s new management is probably two months into a three-year turnaround, which involves a radical restructuring including the divestment of its investment banking operations. There may not be a fundamental rationale for concern, but this will continue to be a challenging time for the bank.

Finally, remember that turbulent markets do reveal opportunities. Smart investors are on the lookout today, and that is also a global phenomenon.

 

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.

Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.

Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.

Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. Buying and using blockchain-enabled digital currency carries risks, including the loss of principal.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

IMPORTANT LEGAL INFORMATION

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data.  Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

Get Content Alerts in My Inbox

Receive email alerts when a new blog is posted.