A few weeks ago, a series of banks across the Atlantic fell into trouble. In the US, as we discussed in our previous column, the Silicon Valley Bank went into receivership as the rise in policy and market rates made the simple, poorly managed business model of the bank (namely, gathering cash deposits and investing them in long-term Treasury bonds) miserably fail. Last week, the Fed released a report on this failure and blamed both the poor risk-management of the bank, which did not hedge against the interest rate risk and maturity mismatch, as well as the too-soft supervisory oversight by regulators. According to the Fed, the regulators’ action was weakened by the reforms made during Trump era, which had called for a less intrusive approach.
The other US banks that were in trouble were Silvergate and, in particular, First Republic Bank. In the latter case, a group of 11 banks pooled resources to put together a rescue plan worth around $30 billion, in an attempt to stop the slide on the banks’ equity prices, which had collapsed by 90% from their peak of $219, reached at the end of 2021. As we said in our column, “It is not yet clear whether this rescue plan will be effective, as the fall in the banks’ equity prices has not yet stopped.” Now we know it has not worked, because the Fed has asked other financial institutions, including JP Morgan and PNC, to express an interest in the acquisition of the bank.
In Europe, Credit Suisse was acquired by UBS with a “burden-sharing” approach that left everybody unhappy, apart from the management of Credit Suisse which got away with some form of a golden parachute. Most importantly, the market quickly turned its eyes against what was perceived to be the next weakest link, Deutsche Bank, which underwent severe stress when a small bet on its credit default swaps (CDS) hit the market.
Second, as I argued at the recent G30 meeting in Washington, the apparatuses that have been put in place after the GFC to avoid a repetition of the serial banking failures of that period may not be proving fit for purpose. The return of blanket guarantees on deposits and the fact that regulators, instead of resolving troubled banks, always try to sell them to larger willing institutions, suggest that the instruments devised to resolve crises may have not worked when tested against reality. In this respect, it is scary to note that the total assets held by the twoFDIC-insured banks that have failed in 2023 (at USD 319bn) are almost as large as the combined assets of all failed banks in 2008.
Third, as a consequence of the first two points, the risk remains that an episode similar to what happened to Deutsche Bank a few weeks ago may repeat itself. If it does, the government might then panic and announce that ALL deposits will be guaranteed. In 2008, this was the beginning of the end for Ireland, which first announced a blanket guarantee on deposits. This put the government in a very precarious position, from which it was rescued only by the ECB activating an ELAand the government issuing a promissory note. This was the beginning of the doom loop between government debt and banking debt that worsened the Euro crisis and proved hard to break. If a government were to do that again – and a simple line during the evening news such as “all deposits will be guaranteed by the government” may be enough for it to happen – we may see a return of the “doom loop.” At that point, central banks, even if they are busy fighting inflation, would need to reconsider their stance and prioritise the solvency of the government and the banking system over the fight against inflation. They might need to cut rates and re-start QE.
As we have said, during the 2007-2008 financial crisis, it took one year between the Northern Rock bank run and the collapse of Lehman Brothers. This is the reason why it is essential that regulators, in the year ahead, will try to “fix the roof until the sun shines”, as Christine Lagarde used to say when she was the head of the IMF, and adopt the necessary reforms to prevent the isolated cases of recent days from becoming systemic events in one year’s time.
For this reason, Michael Barr, the Fed’s bank-supervision chief, called for an overhaul of how the Fed oversees US financial firms. The Fed will revisit the various rules that apply to institutions with more than USD 100 billion in assets, including stress-testing and liquidity requirements. Regulators could require additional capital or liquidity, or limit share buybacks, dividend payments, or executive compensation when firms exhibit inadequate capital planning and poor risk management.
Regulators across the board are trying to say that these are idiosyncratic cases, which do not necessarily need to be precursors of a more systemic financial instability episode. We dissent from this interpretation, for the following reasons.
First, all banks have been subject to the same shock, which was the rapid, large, coordinated increase in interest rates across the globe. Up to a certain point, for well-managed banks, higher rates are a bonanza, as banks can charge more for the money lent, while being slow in adjusting the remuneration of their deposit, in the absence of real competition. But above a certain level (that the Fed named r**), higher rates are detrimental because of their impact on overall financial conditions and on the strength of the economy, which is the most relevant factor in determining the ability of borrowers to repay their debt.
