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Banks and regulators feel that “everything everywhere all at once”

Bank failures occur frequently in history. Some banks run into trouble due to mismanagement or even fraud, get taken over and people forget their existence. Barings was one of such cases. It was taken over by ING. Nick Leeson served his jail sentence and is now a coach. And its collapse did not cause a full-blown banking crisis around the world.

But the crisis in 2008 was clearly widespread, affecting banks in Iceland, the US, US and Europe. The turmoil that we have been seeing this time was triggered by a small West Coast lender in the US. The biggest casualty is on the other side of the Atlantic, where Credit Suisse was forced to be taken over by UBS.

For banks, everything bad seems to be happening everywhere in the world all at once. A small event propagates across the multiverse of banks of different sizes, in different regions with different business focus. Regulators are nervous and want to contain the damage from spreading. Banks are nervous over whether the loss in confidence will become more universal and affect their deposit base. From a risk and regulation perspective, there are three immediate observations.

First, banks are more integrated than ever before and hence exposed to other economic sectors. This has always been the case due to the utility role of banks in providing deposits and loans. But easy money and low rates since the global financial crisis and COVID means that connection is closer. Both banks (for their shareholders) and their clients need investment returns and started taking more risk. Big, globally systemic important banks are complex creatures due to their size. But when a group of small banks are indirectly connected to a few economic sectors, each one becomes part of a large complex system. Managing and understanding the risk of one bank is not sufficient. We need to also look outside the bank and consider the larger picture.

Secondly, as many commentators and economists have pointed out, banks rely on public trust to function properly. Stakeholders like depositors and borrowers are equally, if not more, important than shareholders. The loss of trust triggers deposit runs and sell-offs in shares. Both create stress to the bank’s balance sheet. A liquidity squeeze ultimately leads to insolvency. Nowadays, digital technology means bad news (even if it is fake or just rumours) spread quicker. It only takes seconds for a depositor to swipe on the phone or click on the laptop to withdraw deposits. Same for investors in selling bank shares. This is why Silicon Valley Bank and Credit Suisse, banks with completely different size, geographic scope and business focus both got into trouble. The loss of trust in one bank quickly snowballed into panic, initially in one region, then to one country and then globally.

Thirdly, regulators continue to be confronted with the challenge of maintaining stability in the banking system by avoiding panic and loss of trust. Since the global financial crisis, regulators strengthened bank balance sheets, established a stronger regime to deal with risks of systemic important banks, and set up resolution procedures to deal with bank failures. They are probably good to deal with the last crisis if it happens again. But as the current turmoil shows, market distress can be different every time. This time the main problem is not credit risk (sub-prime) but interest rate risk on safe assets. Strong financial ratios and balance sheets cannot stop depositors and shareholders losing trust when they panic. When regulators need to choose between sticking to the rules that they wrote and the need to stop panic, the latter would take precedent, even if it means they rip up the rules they wrote. Perhaps they do not need to do so, but the risk of causing more damage (albeit at small probability) outweighs rational economic arguments about moral hazard. A FT Lex column commented that “tools and understandings [of regulators] are more sophisticated than in the past. But the underlying dilemma has not changed.”

What we are seeing is the result of more than a decade of easy monetary policy. We can criticise the management of SVB and Credit Suisse. We can accuse the regulators of overlooking the collective risks of smaller banks. We can criticise the regulatory framework established since the global financial crisis of being imperfect (though as the current turmoil shows, I am not sure we can ever get perfect banking regulations). But in the short run, rebuilding trust in the system is the most important thing. It takes more than numbers and rules. Be prepared for more drastic actions by central banks and regulators to avoid further panic – even if they require throwing out the rules and costing taxpayers.

James Chu CFA

Head of Investment Solutions

Keywords: Banks, Financial crisis, Regulations

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