Banking Crises: size doesn’t matter

The global financial system nearly collapsed in September 2008 when “globally significant” bank Lehman Bros failed, insurance company AIG (which insured many securities) had to be bailed out and numerous “mergers” were encouraged by panicked regulators.

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The system didn’t nearly collapse early this year when Silicon Valley Bank (SVB) failed, along with some other American regional banks, and “globally significant” Credit Suisse was forced to merge with fellow Swiss giant UBS.

"In practice, the ‘maintenance’ of the bank regulatory and supervisory framework has often been challenging, in part because maintenance requires vigilance in responding to evolving circumstances and risks” - Michelle Bowman, US Federal Reserve System board governor 

But it would be wrong to think the measures brought in following the financial crisis (GFC) have now been battle proven. Indeed, significant issues – some the result of policy mistakes, some of being mugged by reality – have become clear.

The good news is the banking system is now considerably better capitalised meaning there is a far lower chance of an insolvency crisis.

The bad news is two emergency measures developed in the aftermath of the GFC failed – the ranking of banks into globally, domestically and regionally significant banks; and the “living will” recovery and resolution plan for when things go awry.

The other bad news is the attention span and institutional memory of governments and regulators in too many jurisdictions – notably the US under the Trump ‘administration’ – seemed to disappear, meaning several important safety measures were dismantled.

This shouldn’t be a surprise. Indeed, the regulator’s prayer is often framed as “please give me frequent crises – just not big ones”.

The US Federal Reserve’s Michelle Bowman articulated this well in a recent speech,  The evolving nature of banking, bank culture, and bank runs.

“In practice, the ‘maintenance’ of the bank regulatory and supervisory framework has often been challenging, in part because maintenance requires vigilance in responding to evolving circumstances and risks,” she said.  “Lapses in this effort are revealed when something breaks, which could include fragilities resulting from the emergence of unidentified risks and financial stability threats; banking practices that expose shortcomings in the supervisory framework; or policymakers, regulators, and/or examiners who have lost sight of the fundamental goal of encouraging prudent banking practices and appropriate risk management.”

This was starkly illustrated earlier this year and the “maintenance” program was found wanting.

There were successes. As the International Monetary Fund noted “the banking system has much more capital and funding to weather adverse shocks, off balance sheet entities have been unwound, and credit risks have been curbed by more stringent post-crisis regulations.”

Yet this year’s crisis, which was more akin to the US Savings & Loans crisis of the 1980s than 2008, demonstrated the pressures of a steep and rapid rise in interest rates which broke some fast-growing financial institutions unprepared for the rise – as were some regulations.

The IMF pointed the finger at the false distinction between small, medium, large, local and global banks - including the post-GFC order which established Globally Systemically Important Banks (GSIBs) and Domestically Systematically Important Banks (DSIBs).

“We learned that troubles at smaller institutions can shake broader financial market confidence, particularly as persistently high inflation continues to cause losses on banks’ assets,” the IMF said.

“Faced with heightened risks to financial stability, policymakers must act resolutely to maintain trust. Gaps in surveillance, supervision, and regulation should be addressed at once. Resolution regimes and deposit insurance programs should be strengthened in many countries. In acute crisis management situations, central banks may need to expand funding support to both bank and nonbank institutions.”

There had been an ultimately misguided view that shocks could be bulkhead-ed – or indeed Balkanised – so that a failing smaller bank would not impact the wider system and larger banks would be more intensely scrutinised, regulated and ultimately operated so they could be unwound in a crisis without sinking the whole ship.

But SVB and Credit Suisse showed the bulkheads would not hold. At least there wasn’t a Titanic scenario.

The general and investing public, retail and institutional, don’t recognise the nice distinctions bank regulators set up. The, largely tech companies, which held deposits with SVB drastically in excess of what was covered by government deposit insurance had little understanding of the vastly different risks they were taking.

Moreover, when it began to dawn on them, the bank run which ensured was of a speed and scale not experienced before, almost instantly hitting trust in the broader system, despite the fact the collapse of SVB and a few other specialist, regional banks should’ve had no impact beyond their immediate ecosystems.

There were two factors at play here which differed to 2008: social media and the ease of withdrawing funds in an always-on digital world. After Silicon Valley Bank collapsed last month, a group of economists analysed the content of more than 5 million tweets and concluded “social media exposure led to bank run risk rather than simply reflecting it”.

This means when there is a crisis of trust, at almost any point in the system, governments and regulators must be prepared to act instantly – most probably with lines of liquidity to counter the run – while also creating greater clarity in the community around the inevitable risks in the banking system which people need to be aware of. This year taught us depositors and lenders will panic and act before they sit back and assess the stability of the system.

Once again it should be noted not all jurisdictions performed equally. It is widely accepted the US had the most flaws, primarily due to the easing of regulation by the Trump regime in response to lobbying. US regulators have been upfront about this.

"Following Silicon Valley Bank's failure, we must strengthen the Federal Reserve's supervision and regulation, based on what we have learned," said Michael Barr, the Fed's vice chair for supervision, in a welcomely frank 114-page report. That report found, beyond the watering down of post-GFC strictures, supervisors were slow to grasp the extent of the problems at SVB and, when problems were identified, supervisors failed to move aggressively enough to ensure those problems were fixed.

Again, the attempt to rank banks in terms of systemic importance and regulation was found to have failed: changes adopted in 2019 that exempted all but the biggest banks from strict scrutiny — along with a cultural shift towards less-assertive policing of banks — allowed problems at SVB to fester until it was too late.

The issue is not only are size distinctions no longer relevant for perceptions of systemic risk, nor are geographic ones. This was true in the GFC and even more significant in this latest mini-crisis when Australia, for example, which is recognised as having one of the safest and most scrutinised systems in the world, nevertheless saw volatility in the banking sector and beyond.

As EY said in its review of the latest Australian bank reporting season: “Fortunately, Australia’s strict capital adequacy regime means domestic banks are well-placed to weather the current market instability. Along with large capital buffers, the banks’ strong holdings of liquid assets, conservative funding strategies and focus on traditional banking activities have bolstered the Australian financial system.”

Furthermore, the regulatory and supervisory regime is well “maintained” in Australia and New Zealand (and also in major European economies and Japan). And that is ongoing with a review by the Australian Prudential Regulation Authority of resolution planning including the assessment of “critical functions” and interconnectedness looming.

Bank regulation needs not only regular maintenance but sometimes renovation.

Andrew Cornell is Managing Editor of bluenotes.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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