Banks and the Butterfly Effect—the Global Ramifications

by Stephen Dover of Franklin Templeton, 3/16/23

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.