Early lessons from the  recent banking turmoil
Early lessons from the recent banking turmoil

Early lessons from the recent banking turmoil

Lucrezia Reichlin argues that protecting taxpayers’ money remains the ultimate goal when dealing with banking crises.

Advertisement

What started with the collapse of Silicon Valley Bank on March 10 was followed by strains in other US regional lenders before the failure of Credit Suisse a week or so later and most recently of the US’s First Republic. 

In a conversation with F&D’s Marjorie Henriquez, Lucrezia Reichlin (LR), a Professor of economics at the London Business School, discusses the state of financial regulation and why the recent events call for a reflection on the future of central banks. 

F&D: Do the recent bank stress events have common elements? Should we expect other institutions to topple amid higher interest rates and tighter financial conditions?

LR: The US and the Swiss crises are different. The first involves midsize banks with assets dominated by safe government bonds, whose mark-to-market value declined as interest rates increased, and deposits concentrated on a particular sector.

The second involves a very large institution with long-standing idiosyncratic problems more broadly defined. 

However, both crises show regulatory failures and poor risk management, and they were both triggered by the increase in interest rates related to the synchronised and harshest monetary policy tightness we have experienced since World War II.

In these circumstances, financial fragility must be expected in those parts of the system which are badly managed, poorly regulated and more exposed to tight credit conditions. 

F&D: Is the global financial system strong enough to avert a banking crisis?

LR: I expect other banking crises to happen, especially if central banks continue to tighten monetary policy.

Banking crises cannot be prevented in all contingencies, at least not in a fractional reserve system where loans don’t need to be fully backed by deposits, like the system we have today.

The recent crisis is a painful reminder of the fundamental instability of banks’ business models.

One question is whether the crisis management framework we have in place can prevent generalised contagion when one institution fails.

I believe that we’re well equipped to face generalised liquidity crises through central banks’ interventions.

In recent years, central banks have proactively intervened as liquidity providers and learned to do this in a timelier manner than in the past.

In principle, we also have tools to deal with the insolvency of a single institution.

However, those crises are rarely managed in an orderly way. Today, if the world economy were to plunge into a deep recession, we are likely to see many cases of institutions facing solvency problems that will test this assertion.

The Credit Suisse episode rings an alarm on whether we can be confident that problems can be solved following the rulebook.

If a bank is failing, the regulator can seek resolution with a bail-in or a bailout.

A bail-in in theory is a good option to protect taxpayers, but in some cases, a bailout may be wiser.

The way to think about the choice is that a bail-in may cause financial instability while a bailout causes moral hazard and is an implicit subsidy to the banking sector.

In many cases, the crisis of one bank is addressed by a national regulator facilitating a merger with a national bank, either by moral suasion, subsidy or both.

Advertisement

This was the case in Switzerland, where UBS was encouraged by the regulator to absorb Credit Suisse at a very unfavourable exchange for Credit Suisse shareholders. Such a solution is not always feasible.

In the case of Switzerland, another merger would not be possible since UBS is now the only national bank and a cross-border merger would involve authorities with different national interests.

The distinction between systemic and nonsystemic institutions, on which the postcrisis regulatory framework is based, is useless.  

F&D: How would the European Union manage a bank failure?

LR: In the EU, there are questions about the adequacy of the existing resolution framework; managing a cross-border banking crisis remains difficult.

Advertisement

There are also questions about the EU resolution rules.

The Banking Recovery and Resolution Directive prevents any bailout before eight per cent of the unweighted balance sheet of a troubled bank has been bailed in.

As Mathias Dewatripont, André Sapir and I have pointed out, the problem is that many of the smaller and midsize banks cannot satisfy the eight per cent bail-in rule without hitting depositors, as they do not hold enough debt that can be bailed in.

For such banks, the US approach to Silicon Valley Bank would be illegal. Under these circumstances, if a banking crisis were to strike today, there would be a risk of financial instability.

Advertisement

Another concern is that deposit insurance is low in the EU, at only 100,000 euros, and there is no systemic risk exemption, unlike in the US, where depositors can expect to be protected in cases where a bank’s collapse would pose a risk to the entire financial system.

This, combined with the fact that the banking union doesn’t involve common deposit insurance at the EU level, makes the system fragile.

When there is tension in the market, nonresident deposits flow toward countries which are safer from the public finance standpoint, while banks hold bonds of their own sovereign on the asset side.

This creates market segmentation and a vicious cycle of risks between banks and sovereigns.

F&D: Central banks are facing increasingly difficult trade-offs between their twin goals of price stability and financial stability. Can they still achieve both?

LR: Central banks today have many tools. The short-term interest rate is the principal instrument in a tightening cycle, and a liquidity injection can be implemented to deal with financial stability problems without jeopardising price stability.

We now have many examples that prove this point, including the effective handling of the Silicon Valley Bank crisis by the US Fed.

Squeezing credit is part of the process of monetary tightening. When former Chair of the US Fed Paul Volcker was asked by former Fed Vice Chair Alan Blinder how he thought monetary policy worked to crush inflation, he replied, “by causing bankruptcies.”

Some parts of the system will run into solvency issues as a consequence of monetary policy tightening.

After the tightening by Volcker’s Fed in the early 1980s, we had Continental Illinois and the savings and loan bank crises. In principle, regulators can prevent these crises, but history proves that regulators are often behind the curve.

If a crisis happens, fiscal authorities and institutions like the Federal Deposit Insurance Corporation will have to deal with it. As mentioned earlier, the question is whether these crises can be handled without costs to the taxpayers.

F&D: What are some early lessons policymakers should be drawing from the recent financial sector turmoil?

LR: Let me start with the crisis initiated with the Silicon Valley Bank in the US. The Fed’s post-mortem evaluation indicates that there was a failure of risk management, supervision and regulation, but I think we can draw two more general lessons.

The first is that not only big banks but also midsize banks can create contagion; when this happens, intervention by public authorities is required to stop it.

The distinction between systemic and nonsystemic institutions, on which the postcrisis regulatory framework is based, is useless. All crises have potentially systemic effects.

A second lesson is that all deposits are potentially volatile; partial deposit insurance is not credible. In the case of Silicon Valley Bank, all depositors were bailed out, and this was a gift to wealthy depositors.

One solution is to insure all deposits ex-ante, but this would be expensive.

Maybe we should consider a more radical solution—reforming the system drastically in the direction of central bank digital currency or narrow banking, with financial institutions limiting their activity to low-risk short-term investments.

This, of course, would have consequences for the banking industry that must be carefully considered.

As for Credit Suisse, it is too early to draw lessons as many questions remain unanswered.

The Swiss solution was, perhaps, effective in preventing financial instability, but it involved the government compensating UBS for potential losses; I doubt it will be costless for taxpayers.

And now they have created a monster bank, much bigger than the Swiss state. This shows that a bank’s death is always messy and costly. This should lead to a broader reflection on the banks’ business models and potentially safer alternatives.

F&D: First Republic, which was acquired by JPMorgan recently, became the second-biggest bank to fail in US history. Did federal regulators act quickly enough?

LR: It looks like US regulators are better at crisis management than at crisis prevention.

The problem of First Republic was fixed fast enough, but the terms of the deal with JPMorgan are still untransparent. JPMorgan obtained a $50 billion, 5-year fixed-rate loan from the Federal Deposit Insurance Corporation at an interest rate which hasn’t been disclosed.

With the information we have so far, it looks like the deal is very favourable for JPMorgan. And the crisis doesn’t stop there. More midsize banks are under threat, and the stocks of large banks are also failing. So we have to ask the important questions: why did this happen and are present regulations appropriate? — IMF

Connect With Us : 0242202447 | 0551484843 | 0266361755 | 059 199 7513 |

Like what you see?

Hit the buttons below to follow us, you won't regret it...

0
Shares