When a banking crisis threatens because of three banks representing less than 0.5% of the world’s banking assets, you know the rules are not adequate
My tu’ppence, where is my tu’ppence?
Remember little Michael Banks asking for his tu’ppence in Mary Poppins musical film and provoking the collapse of the bank employing his father? If you don’t, watch it again: there is not much more to know about bank runs. By construction banks are not in a position to pay back instantly all the deposits they have received from their customers, and the minute customers no longer believe the money they have deposited is safe, the stampede starts and the bank collapses. This is what we saw in the past few days with Silicon Valley Bank’s customers queuing to get their money back and with daily deposit outflows topping CHF 10 billion at troubled Credit Suisse. The common denominator between Silicon Valley Bank and Credit Suisse is, in otherwise non comparable situations, the loss of trust. No trust, regardless of the reason for the loss of trust, no bank.
The essential question to ask ourselves from a systemic standpoint is not why Silicon Valley Bank was foolish enough not to hedge the interest rate risk on its portfolio of bonds deemed “available for sale” (the response is that hedging costs money) or why Credit Suisse has been jumping from one crisis to the other for several years (the response is greed and lack of adequate governance), but why and how the failure of three banks (if we include Signature Bank) representing together less than 0.5% of the world’s banking assets (the equivalent of two pence in the grand scheme of the global banking world) can threaten the entire system.
Does the fact that all banks are now under pressure indicate that financial market participants, who are not the less well informed nor the less knowledgeable about the banking system, do not trust that prevailing prudential rules are sufficient to ensure the stability of the banking system?
The short answer to this question is yes, and there are two main reasons for this:
1) Substantial exemptions to the internationally agreed Basel III framework have been adopted in the US as well as in the EU:
2) Even if it were properly implemented, the Basel III framework is not so demanding in the first place. Basel III may have multiplied by 3 or 4 the capital of banking institutions and improved their liquidity ratios, but we were starting from such a ridiculously low base under Basel II (on a non-risk weighted basis, banks’ capital requirements were often under 1% under Basel II) that those requirements remain modest and are far from protecting banking institutions from all possible events. This weakness is reinforced by the fact that Basel III looks at banks as separate entities but never in relation to one another: this is a huge flaw given the high interconnectedness of the banking system.
Faced with declining stock prices, the CEOs of systemic banks are complaining that the market does not understand how resilient their institutions have become thanks to the prudential rules applying to them now. The reality is that financial market participants understand very well what the rules in place mean. By voting with their feet, they send the message that they do not trust that those rules are sufficient by themselves to make for a resilient banking system. They also know that public authorities will have to intervene each time the situation becomes difficult. If it had not been for the trillions injected by central banks in March 2020 when the Covid-19 crisis burst out, the financial system would have collapsed. Similarly, the deal negotiated over the weekend by Swiss authorities for UBS to acquire Credit Suisse on terms never seen before shows not only how bad the situation is, but also that existing rules are not sufficient when things go sour.
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When prudential regulation fails, the last line of defense to protect society from the consequences of failing banks is resolution. Unfortunately, despite the resolution frameworks that have been put in place, we live in a world where there is no longer any such thing as a bank small enough to fail without being bailed-out. In the EU since 2016, Banca Popolare di Vicenza, Veneto Banca, Banca Carige, Monte dei Paschi di Siena and NordLB have been saved with public money. In the US, the authorities did effectively the same thing last week by guaranteeing the uninsured deposits of Silicon Valley Bank and Signature Bank (“Good news: the rules have changed in your favor”). In the US like in the EU, even small banks have become too-big-to-fail, or perhaps too-politically-connected-to-fail. The detail of each situation is different but the principle is the same: public money goes into bailing-out non-systemic banking institutions or their private creditors. Despite the official rhetoric and all the rules adopted since 2008, moral hazard remains the dominant principle in banking: the upside goes into private pockets and the downside is covered by public budgets and central banks, in other words by society.
This week, Members of the European Parliament who want to be reassured that the situation is under control will grill European banking regulators. When it comes to financial stability, banking regulators and central bankers are the firefighters whilst legislators are the architects in charge of building a house following proper fire safety standards. It feels somewhat ironic that EU banking regulators should be grilled by MEPs when their most senior representatives (Luis de Guindos, Vice-President of the ECB, Andrea Enria, Chair of the Supervisory Board of the ECB and José Manuel Campa, Chair of the European Banking Authority) warned the EU co-legislators as recently as last November of the dangers of diluting the Basel III rules, and the ECON Committee of the European Parliament superbly ignored their warning and diluted Basel III when it voted on the EU banking package on 24 January.
Perhaps we should have the regulators grilling the co-legislators instead. Or the co-legislators held accountable by European citizens for giving in to the siren calls of the banking lobby against the advice of their own regulators.
We can rest assured that central bankers will do whatever it takes to prevent the banking system from collapsing and it is the right thing for them to do. When the house is on fire, the first priority is to put out the fire. However, the cost to society will be enormous as citizens will be left footing the bill once again and the banking system will continue operating without discriminating between the banks serving society and those that do not. This is no longer acceptable.
We need to reinforce internationally agreed prudential and resolution rules and stick to them.
Thierry Philipponnat
Chief Economist, Finance Watch