How speculators are profiting from the banking turmoil

When a publicly traded company is in distress, speculators may aggressively bet on the decline of its stock value. The ongoing banking turmoil presents a case in point. Recently, there has been a pronounced downward pressure on regional banking stock in the USA. For example, The PacWest Bankcorp and Western Alliance Bancorporation saw sharp declines in the value of their equity during the last week of April and the first week of May.

In addition to trading on individual banks, speculators have been very active in trading on exchange traded funds that hold banking stocks. During the first week of May, the SPDR S&P Regional Banking ETF saw an unusually high put option activity. On May 3rd, the price of the ETF dropped by the staggering amount of 7%. This is very unusual, as the ETF is broadly-diversified, holding regional banks spread across the whole of the USA. However, the sharp decline in value illustrates the significant selling pressure by speculators.

Corrective function

Broadly speaking, there are two ways in which speculators profit and drive these negative price trends.

The first one is short selling – a speculator borrows a share from another institution and is obliged to return it to its original owner after a specific time period. For example, suppose that the current price of a stock is 100€, but a speculator believes it is likely to decrease. He can borrow the share from an institutional investor (for a fee of a few cents) and promises to return it in a month. Upon borrowing, the speculator sells the share on the open market and later buys it again, in order to return it. If the price declines during that period, then the speculator profits from the decline. Thus, if the price declined to 90€, the speculator profits 10€.

The second way in which speculators can profit from declining asset and company values is via trading derivatives. There are different derivative contracts, but I will illustrate the idea using an example of one of the simplest instruments to use – put options. These options represent a contract giving the option buyer the right, but not the obligation, to sell a specified amount of an underlying security at a predetermined (strike) price within a specified time frame. Since the selling price is determined at the time the option is purchased, the speculator can significantly benefit from a price decrease. For example, a speculator may purchase a put contract with a strike price of 100€ that expires in three months. If the price declined, then the speculator makes a profit – he buys the stock for 90€ and then exercises his option to sell it for 100€. The difference, minus the cost of entering into the put contract, represent the profit for the speculator.

Selling activity on financial markets is often negatively perceived. However, it has a very important beneficial side. Suppose an asset is overvalued. Investors who understand the fair valuation of the asset can trade on that “negative information” in order to bring the price closer to fundamentals. For instance, when the market realizes that the sales of a given company are lower than expected, investors can short sell the company’s equity. The competitive market forces then come into place – when more people want to sell than buy the stock, the buyers would only be willing to purchase the stock at a lower value. Thus, the value of the asset declines.

Negative spiral

A long line of academic research demonstrates the importance of short selling for making prices more efficient. After all, investors want to hold assets at their fair prices and selling activity, either via short selling or trading on the options market, brings prices closer to fundamentals.

The problem occurs when certain investors (i.e, speculators) bet that their excessive trading would make the trade even more profitable. In the example of the regional banks outlined above, speculators may engage in excessive short selling that results in price decline below the fundamental, or “true” value of the company. If the market value of the affected banks becomes “too low”, then they would have a harder time keeping depositors and remaining investors happy. A negative spiral can unfold – speculating activity leads to price declines, which prompts more depositor outflows, which in turn creates further downward moves in the stock value. The probability of bank failure thus increases.

Banks are very important financial institutions. They are strongly interconnected – the problems of one bank can easily spread to other banks. The reason for this is that banks loan heavily to each other and are exposed to the same types of risk. Thus, an excess in speculative activity can amplify the price of decline of the market equity of banks and spread the problems to other banking institutions.

Since the beginning of 2022, the US central bank (the Federal Reserve, or Fed) has been gradually raising its key rates (the rates at which it lends money to commercial banks) in order to combat record levels of inflation. This monetary policy is a new constraint for regional banks in difficulty: borrowing from the Fed is becoming more expensive. The chains, which are paying more for the funds they need, could therefore pass on this increase in the rate on their commercial loans, thereby restricting their customers' demand for credit and their business. Regional banks could therefore remain in the hands of speculators over the coming months.

As far as Europe is concerned, there is an additional risk that credit costs will rise. Banks gradually turned away from the European Central Bank (ECB) as interest rates rose from mid-2022 onwards. In addition to that, banks in the ECB have been gradually moving away from the financial support of the ECB as European banks have been paying hundreds of billions in cheap loans back to the ECB. This reduction in cheap liquidity supply from the ECB would eventually translate to higher funding costs in the wholesale funding market.

Thus, if the current troubles in the banking sector become more intense in the Eurozone, banks might have to resort to more expensive funding that could drive further speculative trading.

This article by Teodor Dyakov, EDHEC Business School Associate Professor, has been initially published in French in The Conversation under Creative Commons licence. Lire l’article original.

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