While the banking crisis of early 2023 has subsided, persisting vulnerabilities could lead to more turmoil.
In a nutshell
- The 2023 crisis has exposed unresolved banking vulnerabilities
- Some European banks are still undercapitalized
- Regulatory distortions exacerbate financial sector risks
When is a crisis a crisis? The question resurfaced in March of this year after the global banking industry was thrown into turmoil again. All around the world, experts got into heated discussions over whether this was just a series of isolated events or the prelude to a new worldwide financial crisis.
By now, the storm has calmed down. It has become clearer what really happened this last March, during which “hundreds of billions of dollars in global wealth” allegedly vanished into thin air. The far-reaching consequences of this episode on the financial system and its impact on the real economy are now being evaluated with a broader perspective.
Cascading failure
The new banking drama began when Silvergate, Silicon Valley Bank and Signature Bank, three of America’s most crypto-friendly lenders, collapsed within less than a week. Other banks, like First Republic, only narrowly escaped what was promptly dubbed “the first Twitter-fueled bank run.”
Market panic quickly spilled over to Europe, leading to the downfall of Credit Suisse, an institution included on the list of Global Systemically Important Banks (G-SIBs). In the blink of an eye, Switzerland was close to facing a full-scale bank run. Several other eurozone banks, among which Deutsche Bank (another G-SIB), came under pressure as investors dumped their shares en masse.
To prevent panic from spreading, governments and central banks stepped in literally overnight and gave the troubled financial institutions historic rescue packages and emergency deals. They claimed these were not taxpayer bailouts like those implemented during the 2008 financial crisis. Indeed, this time most of the money came from insurance funds paid by banks, or was provided to them in the form of loans.
Still, the situation evokes an unmistakable sense of deja vu. A new crisis of trust has emerged. Citizens, both as banking clients and taxpayers are affected, at the very least indirectly through inflation, by these massive bank rescue programs. They question how systemic risk from banks can persist in 2023. Had they not been promised “the end of too-big-to-fail” years ago?
Too big to save
Eventually, UBS, Switzerland’s biggest bank, was required by the government to buy its long-time rival Credit Suisse for three billion Swiss francs ($3.25 billion). The takeover announcement came on March 20, following the Swiss National Bank’s unsuccessful attempt to quell the confidence crisis using a 50 billion-franc ($54 billion) liquidity backstop.
Whether the forced marriage will be successful is another matter. Some analysts already worry that after this spectacular merger, UBS’s market share in Swiss banking could exceed 30 percent. Moreover, the new entity’s combined assets (nearly $1.7 trillion) will be twice as large as Switzerland’s annual gross domestic product.
What if such a colossus collapsed? Who could come to its rescue? Individually, UBS and Credit Suisse may have been “too big to fail” but, to use the words of German economist Hans-Werner Sinn, the new mega-bank could turn out to be “too big to bail.”
Clearly, failure is not an option. The impact would be catastrophic not only for Switzerland, but for the global financial system. It should not be forgotten that 15 years ago, UBS itself needed rescuing by the Swiss government and central bank.
Walking on eggshells
All the recently failed lenders had struggled, often for years, with several issues: high indebtedness, excessive risk-taking, unreasonable exposure to liquidity risk, mismatch between assets and liabilities, poor investment performance, mismanagement and sometimes downright fraudulent business practices (in the case of Credit Suisse, even a spying scandal). Customer trust eroded, precipitating the failure of the institution and ultimately sending shock waves across the highly interconnected global financial system.
According to some observers, what happened last March was more of a “sentiment contagion” than a “true systemic contagion.” But policymakers know all too well that fears of financial crises can quickly become self-fulfilling. That is why their first priority, in the midst of the chaos, was to reassure markets with a clear message: this instability is due to idiosyncratic cases and has nothing to do with what happened in 2008.
United States President Joe Biden promised bank customers that “their deposits will be there if and when they need them.” Federal Reserve Board chief Jerome Powell reiterated the promise.
Christine Lagarde, president of the European Central Bank (ECB), stated that “the euro area banking sector is resilient, with strong capital and liquidity positions.” In any case, “the ECB’s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed, and to preserve the smooth transmission of monetary policy,” she added.
Policy spillovers
One may wonder whether it was a coincidence that a mini-financial crisis erupted just a few months after the world’s major central banks began raising interest rates at a speed unseen in decades to cool inflation. What if this drastic monetary tightening made the banking sector crack at the seams?
Rising interest rates are a double-edged sword for banks. On one hand, higher rates improve their loan income. On the other, they push up the cost of liabilities and reduce the value of investment securities held as assets.
This can weigh heavily on banks’ investment portfolios – all the more when these contain large proportions of government bonds, as is the case in the U.S. and Europe. Over the last decade, interest rates were kept ultra-low to support central banks’ frenetic money creation. During the pandemic, commercial banks were urged to accumulate substantial amounts of debt from crisis-stricken sovereigns on their balance sheets.
Now an unhealthy mix of soaring inflation, rising interest rates and weaker economic growth could leave banks facing new problems, ranging from steep losses in bond value to higher funding costs and lower loan demand.
After the acute banking stress of the past weeks, a credit crunch could be looming. To adjust to an increasingly unfavorable macroeconomic context, banks have already substantially tightened their credit standards for all loan categories. But that is an additional blow to recession-stricken economies.
Despite the risks, the ECB decided to hike rates again on March 16. The Fed did the same a few days later. So far, central banks have remained largely silent on the issue of how major shifts in monetary policy may exacerbate preexisting vulnerabilities in the banking sector. Perhaps financial turmoil is simply seen as a side-effect of a global economy in search of a new balance.
President Lagarde insisted nonetheless that there will be “no tradeoff between price stability and financial stability.” One hopes she is right and there will be no need for the ECB to sacrifice its current combat against inflation to rescue failing banks.
Vulnerability factors
The 2023 banking crisis may be behind us, but important questions remain. Are banks as safe and sound as financial authorities would have us believe? And if not, does that mean regulation has failed?
Contrary to their American and Swiss peers, European banks have weathered the latest financial storm remarkably well. This may corroborate the ECB’s assertion that they are “solid and well-capitalized,” with “strong liquidity ratios.”
However, as a German global investor observes, European banks in general have abundant capital and liquidity buffers, allowing them to absorb future shocks. But notable disparities persist across countries and bank sizes.
The implication is that certain banks in some parts of Europe are still undercapitalized. How many are there, and how large are their capital shortfalls? Large enough to fail during a prolonged period of systemic financial stress?
Often, these weaker banks were those that massively lent to nearly bankrupt “zombie” firms during the cheap-money era. Nonperforming loans also proliferated during the pandemic, after the ECB had implemented capital-relief measures allowing banks to temporarily use their capital buffers for lending. Now that interest rates are rising and belt-tightening is required, the more fragile (i.e., undercapitalized) banks could be the first to fall. The entanglements of their balance sheets with those of their oftentimes heavily indebted sovereigns could be yet another source of vulnerability. Together, these factors have the potential to fuel future episodes of banking turmoil in Europe.
Scenarios
Over the past weeks, all eyes were on the banking sector. But as the International Monetary Fund recently warned, another global financial crisis might currently be brewing in the rapidly growing alternative finance industry, often referred to as “shadow banking.” This includes a wide range of firms: insurers, pension funds, mutual funds or high-risk hedge funds.
Traditional banks are increasingly hit by the competition from these so-called “nonbank financial institutions” (NBFIs), as well as from disruptive fintech and Big Tech players, or even crypto companies.
Regulatory overkill could be the coup de grace. Since 2008, especially in Europe, banks have been subject to a panoply of extremely stringent and complex rules, restrictions and requirements – notably on capital and liquidity, or on reporting to authorities. Moreover, they are under constant scrutiny from sophisticated systems of prudential supervision.
Regulatory compliance has long become a heavy burden for banks, weighing on their profitability. NBFIs, for their part, are much less encumbered by regulation.
After the bank failures of last month, many policymakers and their advisors call for even stricter regulation of traditional banks. That would make banks’ competitive disadvantage vis-a-vis nonbanks even larger.
Such flagrant regulatory distortions within the ever more competitive financial services industries will likely exacerbate vulnerabilities in both the bank and the nonbank sectors.
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