Can changes made after 2008 protect us from another financial crisis?
Does the Silicon Valley Bank collapse signal banking crisis 2.0?
The recent panic in financial markets began with the collapse of Silicon Valley Bank (SVB), the largest to collapse in the US banking sector since 2008. More aware of the stakes, the US authorities quickly organized the orderly liquidation of SVB, and the Fed has also committed to lending necessary sums to other troubled regional banks on favourable terms.
Yet the banking crisis 2.0 has quickly crossed the Atlantic. Its greatest victim to date is none other than Credit Suisse, one of the giants of European banking and one which had never really recovered from the financial crisis of 2008-2009.
The rescue organised by the National Bank of Switzerland and the regulator led to the takeover of the bank by its major competitor UBS. Banks control the flow of credit which impacts the functioning of the real economy and real consumers. In April, the European Central Bank will publish quarterly credit indicators which will give us the first signs of how the crisis is impacting the volume of credit available to businesses and consumers at ground level.
Systemic risk in banking sector
The emergency commando operation in Switzerland has reduced the tension on the markets and in various European capitals. It also avoids the collapse of the Swiss banking system and the exposure to systemic risk that would have led to a global financial crisis and plunged our economies into recession.
Banks are particularly susceptible to such systemic risk as they are much more interconnected than organizations in other economic sectors. Credit Suisse was one of these ‘systemic banks’ – a bank whose size is such that a bankruptcy would lead to the bankruptcy of other banks, of the banking system and the economy in time. The merger with UBS creates an even larger and and therefore even more systemic banking group. We see this clearly with Credit Suisse where the presence of good ‘prudential ratios’ as required by Basel III, were not enough to prevent it having to be rescued to avoid a domino effect across the sector.
These prudential ratios alone cannot ensure the soundness of the system – they do not help in the case of investor panic (where banks stop lending to each other) or saver panic (a bank run). In the case of Credit Suisse, the panic started to rise when a shareholder announced they would no longer invest in the bank.
What’s different now?
In the aftermath of the 2008 Global Financial Crisis, central banks from across the world came together to agree on reforms to improve regulation, supervision and risk management of the banking sector.
But the reforms of ‘Basel III’ were not implemented overnight. Instead, it is an ongoing process of changes banking supervision.
In Europe, for the time being, the strengthening of controls on financial institutions have largely worked and there is no crisis in the European banking system. These controls include requirements for ‘prudential ratios’ to monitor and determine the stability of a banks’ finances:
These ratios help to avoid interruption of credit in the economy in the event of an economic crisis or market stress. The high level of these ratios, the good health of most European banks and the rapid mobilization of the authorities have prevented a broader panic movement and contagion.
I consider European systemic banks to be to be better capitalised and well-regulated than in the past. However, there are some challenges to be wary of:
1. We are still waiting for the full implementation of Basel III: European Central Bank (ECB) President Lagarde has just reiterated her desire for full implementation of Basel III. Other ECB officials have also sounded the alarm about the prospect of derogating from certain of its provisions:
Many banks used derivatives to change their asset and liability management profile and profit from increases in interest rates.
However, detailed review on a sample of banks revealed deficiencies with respect to the monitoring of risks arising from derivative hedging transactions as well as to the governance around risk transfers between trading book and banking book, leaving room for potentially incorrect attribution of risks as well as profit and losses.
This warning against the unravelling of bank regulatory standards had already been launched by the European Supervisory Authorities in November 2022 in a joint blog from ECB Vice-President Luis de Guindos, ECB Supervisory Chair Andrea Enria and EBA Chairperson José Manuel Campa.
We need strong rules for strong banks. Basel III has what it takes. But planned EU laws might fall behind international standards. The legislative proposal of the European Commission [EU Banking Package] already included several deviations from the Basel III rules. The EBA and the ECB were critical of these deviations, as they would leave pockets of risk unaddressed and could increase risks to financial stability.
Reflecting back on the Silicon Valley Bank collapse that triggered the latest problems, in the United States, small and medium-sized banks were not required to comply with the provisions of Basel III. SVB paid a high price.
2. Bank balance sheets are opaque and hard to read: Despite progress in recent years, banks’ balance sheets remain opaque, making it difficult to take into account the risk borne and generated by these institutions. We believe that further efforts are needed.
3. The existence of shadow banking makes complete management of systemic risk impossible: Shadow banking is where unregulated finance replaces regulated finance. While the banking sector has made efforts to improve its risk control, shadow banking, to which the banking system is connected, is far from it.
What do we find in this shadow finance? Hedge funds, the ecosystem of crypto currencies, capital-investments….
In the absence of stronger regulation, it is difficult to estimate the level of systemic risk of these activities. This financial opacity constitutes a major risk for global finance and therefore our economy.
Europe also faces the risk of interest rate rises
The biggest risk to the banking sector comes from rising interest rates. The European Central Bank recognised the inflationary risk too late meaning it had to raise its rates quickly and sharply.
Since banks are required to hold safe assets on their balance sheets, they hold a lot of sovereign debt. However, faced with very high inflation, Western central banks had no choice but to sharply increase their key rates, which had a very significant impact on bond yields.
This translates into significant losses on banks’ bond portfolios. Since the beginning of 2021, European 7-10-year sovereign debt has lost about 18% of its value. On maturities that exceed 10 years, losses approach 30%.
Banks are therefore sitting on huge losses on their bond portfolio but, a priori, without this having a negative impact on the accounts, since they keep these assets on the balance sheet in a logic of price-to-maturity, that is to say, assuming that they will keep these assets until maturity and will continue to collect their coupons until then.
On the other hand, when for one reason or another, a bank is in difficulty and runs out of cash and has to part with these assets, it takes the loss immediately, leading to capital increases that are poorly received on the stock market, which give a clear sign of weakness in the eyes of investors.
Authorities should be open to different options
With the takeover of Credit Suisse by UBS, the Swiss authorities are opting to create a new banking giant in Europe. We do not believe that this type of transaction is likely to reduce the level of risk in the European banking and financial system.
In the current environment of persistent and even increasing risks, we believe that the authorities need to consider decisions of a different nature. Banks need to be smaller because the fall of a small bank will do less damage than that of a large one.
Their balance sheets need to be more transparent and the most complex/speculative financial products need to be better regulated or even banned. Finally, the implementation of Basel III must be completed as soon as possible.
The risk to real consumers in the real economy
We must not forget the impact in the real economy. Credit, controlled by banks, is the lifeblood of our economies. It seems increasingly inevitable that the banking turmoil of recent weeks will lead to lower volumes of credit (loans) to the economy.
The ECB will publish its indicators on credit distribution in April. These will be the first indicators of the impact of the crisis on the real economy.
As such, the regulator must take firm measures to supervise these financial institutions more vigorously. Banking accidents are not limited to the banking sector.
The Nobel-prize winning economist and former Fed Chairman Ben Bernanke has shown in his work the link between the 2008/9 banking crisis and the economic crisis.
“Bernanke showed that its main cause was the decline in the banking system’s ability to channel savings into productive investments” Bernanke, Diamond and Dybvig explain the role of banks in financial crises, 2022
The challenges of our societies require an economy that is solid on its foundations.