Banking jitters

July 2023  |  COVER STORY | BANKING & FINANCE

Financier Worldwide Magazine

July 2023 Issue

The 2007-08 global financial crisis had significant short and long term implications for financial services. In the short term, banks lost considerable sums through mortgage defaults, while many businesses indirectly suffered and went bankrupt. As financial institutions (FIs) started to sink, governments were forced to provide bailouts to keep them afloat. Some were absorbed by larger entities. Once the crisis abated, and financial services began to recover, efforts were made to reinstate trust in the sector – primarily through increased regulatory oversight, risk management frameworks and reporting requirements. Over the longer term, the crisis spawned a number of new regulatory actions, such as the US Dodd-Frank Act and Europe’s Basel III.

In recent months, however, financial uncertainty has again reared its head, characterised by banking failures in the US, an emergency merger in Switzerland, and government intervention to avert further fallout.

Stumble and fall

In March, US lender Silicon Valley Bank (SVB) collapsed. A crucial pillar of the tech industry, SVB offered financing to firms often turned away by traditional banks. It attempted to raise $2.25bn of capital to plug a $1.8bn hole in its balance sheet caused by the sale of $21bn worth of bonds at a loss. After a slew of startups and venture capitalists withdrew their money en masse, amid fears over SVB’s financial health, it was quickly shut down and taken over by the US government.

The demise of SVB had been on the horizon. External watchdogs and some of the bank’s own advisers identified dangers and potential risks on its balance sheet. Yet none of the concerned parties, including rating agencies, US Federal Reserve examiners or BlackRock consultants hired by SVB, were able to convince the bank’s management team to change direction and adopt a safer plan for growth. More than 90 percent of SVB’s deposits exceeded the Federal Deposit Insurance Corporation’s (FDIC) $250,000 insurance limit. SVB’s failure has cost the FDIC’s Deposit Insurance Fund (DIF) around $20bn.

On the heels of SVB’s collapse, depositors panicked and withdrew large sums of money from Signature Bank, listed by S&P Global as the 19th largest bank in the US as of December 2022. Signature also had high amounts of uninsured deposits, but unlike SVB, it had exposure to the crypto sector. Regulators moved in and shut down Signature in mid-March. A report by the FDIC the following month concluded that the root cause of Signature Bank’s failure was “poor management”. The estimated the cost to the DIF was estimated at approximately $2.5bn.

Meanwhile, in March shares in First Republic Bank tumbled to a record low after a customer deposit flight exceeding $100bn – more than half the bank’s pre-crisis deposit total. Following the collapse of SVB, a group of 11 banks agreed to a $30bn cash injection into First Republic. The rescue funds were provided by peers including JPMorgan, Citi, Bank of America and Wells Fargo. In response, First Republic said it would take action to shrink its balance sheet. Media reports suggested it was exploring asset sales of up to $100bn. First Republic also noted it would cut executive pay and reduce its workforce (at around 7200 at the end of 2022) by 20-25 percent.

Ultimately, the bank was seized by US regulators and sold to JPMorgan Chase in early May. It is the second-largest bank failure in US history after Washington Mutual in 2008. According to the FDIC, the cost of covering First Republic’s losses under the DIF will come to around $13bn.

Banking misadventures were not isolated to the US, however. Over in Switzerland, global banking giant Credit Suisse was subject to an emergency takeover by rival UBS for almost $3.25bn – well below its market value – amid fears that a failure to protect depositors would trigger a new global banking crisis. The deal in March came after a $54bn loan from the Swiss central bank to Credit Suisse had failed to halt a precipitous slide in the bank’s share price. As a result, the Swiss government and the banking regulator, the Swiss Financial Market Supervisory Authority FINMA, quickly brokered a deal, which the Swiss National Bank agreed to support.

Different this time

A handful of high-profile banking collapses in such short order has led to fears of a 2008-style financial crisis – but this time there are other factors at work. “Both the SVB and Credit Suisse situations seem to have been affected by high inflation, which creates problems for institutions which hold a lot of government bonds,” notes Thomas Donegan, a partner at Shearman & Sterling. “However, all banks face those challenges. SVB and Credit Suisse in particular have been hit by specific issues – including, in the case of SVB a significant exposure to the ailing FinTech sector, and for Credit Suisse a lack of confidence in its management.”

There are certainly marked differences between the current economic outlook and the state of the global economy following the 2007-08 global financial crisis. This is, in large part, thanks to measures introduced in the intervening years.

As Alexandra Steinberg Barrage, a partner at Davis Wright Tremaine, points out, compared to the banking system prior to the global financial crisis in 2007-08, the largest banking institutions are now more highly regulated. “They are better capitalised and have undertaken significant measures to plan for operational disruption and potential failure or resolution,” she says. “In 2020, the Financial Stability Board issued a consultation report of ‘too big to fail’ reforms, noting that the largest, most systemically important banks had built up significant loss-absorbing capacity, and that their capital ratios had doubled since 2011. At the same time, this report also noted a number of remaining gaps.

“Putting aside the global systemically important banks (GSIBs), recent bank failures in the US have highlighted how the failure of several large regional banks could potentially have sparked broader contagion and systemic risk,” she continues. “These events should prompt regulators to re-examine the maximum utility of resolution plans, along with enhancements to bank supervision. SVB and Credit Suisse are two vastly different institutions whose failures happened concurrently. While both institutions were impacted by a rising interest rate environment, their failures were caused by unique circumstances.”

With the collapse of SVB, Signature Bank, First Republic and Credit Suisse, alongside ongoing difficulties among US regional banks, it is fair to say cracks have formed in the banking system. But they seem less pronounced than in the run up to the 2007-08 financial crisis. On the whole, a systemic banking crisis so far appears unlikely.

Generally, banks in many jurisdictions are well capitalised, liquid and able to serve their customers and support the economy. Larger US banks still seem stable, in part due to the Dodd-Frank Act. Small and mid-sized US banks continue to face significant risks, however – particularly after aspects of Dodd-Frank were rolled back in 2018, allowing these institutions to escape some of the more intense federal supervision to which their larger counterparts are subjected.

Unlike in the US, in Europe banks of all sizes are subject to the same regulatory and capital requirements. The European banking space therefore seems better equipped to deal with any lingering uncertainty.

“The 2008 financial crisis primarily revolved around asset quality, driven by defaults on mortgage loans that affected their value and revealed insufficient equity capitalisation of banks,” explains Nico Abel, a partner at Cleary Gottlieb Steen & Hamilton LLP. “The current situation is more a liquidity crisis. While strong equity capitalisation reduces the risk of losing the trust of depositors, the current situation has rather raised the question of how to avoid a flight of deposits.”

Persistent problems

Deposit flight remains a concern – particularly for regional lenders in the US. Some US financial groups have experienced higher than usual outflows. On 21 March PacWest, a Californian lender, reported it had lost a fifth of its deposits since the start of 2023. Charles Schwab, State Street and M&T saw almost $60bn in combined bank deposit outflows in Q1 2023, as customers moved their money in search of higher returns. Schwab said its deposits fell 11 percent, or $41bn, in Q1 and 30 percent year on year to $325.7bn. State Street’s total deposits fell 5 percent in Q1 to $224bn – more than expected – and it told analysts that another $4-5bn in non-interest-bearing deposits could leave in Q2. These trends, should they continue, will create greater uncertainty in the banking sector. Some banks may grow nervous about expanding their existing loan books, or continuing to lend at all.

Yet in the interim, there are mechanisms on which banks suffering from deposit flight can rely. They may turn to other financial institutions for liquidity, or to the Federal Reserve’s expanded lending facilities. Official data indicates that American banks borrowed $300bn from various Fed programmes in the week to 15 March. Around $233bn of the total was lent by the San Francisco Fed, which covers banks on the US west coast. On 21 March, PacWest revealed that it had so far borrowed a total of $16bn from various Fed facilities to shore up its liquidity. There was at most around $2bn worth of borrowing from any of the Fed banks that support other regions of the country, indicating that banks in other states have yet to face debilitating deposit flight.

Another problem, however, is interest rates. According to the IMF’s Global Financial Stability Report, risks to bank and non-bank financial intermediaries have increased as interest rates have been rapidly raised to contain inflation. Central bank rate increases are often followed by stresses that expose fault lines in the financial system. The collapse of SVB and Signature Bank were largely caused by uninsured depositors fleeing when they realised high interest rates had led to large losses in the banks’ securities portfolios.

“While unrealised losses on government and mortgage-backed bonds and the flow out of deposits into higher yielding investments – both caused by the increase in interest rates – are probably a more widespread issue, there are certainly considerable differences in the vulnerability of institutions,” points out Dr Abel. “At the same time, actions to protect insured and uninsured deposits, the Bank Term Funding Programme by the Federal Reserve, offering liquidity to depositary institutions against eligible securities at par value, and other government actions have helped to restore the trust of depositors and reduce the risk of further contagion.”

According to JPMorgan, in the wake of the 2023 banking jitters, economists have two major concerns: uncertainty and credit. In terms of uncertainty, fears of a banking crisis and resultant economic pain may lead to a cut in consumption and investment. Uncertainty stemming from banking collapses can reduce annual gross domestic product (GDP) growth by 0.5 percentage points, largely because firms delay investment, according to the International Monetary Fund (IMF). If such a hit were to materialise, post-SVB and Credit Suisse, global growth would fall from 3 percent to 2.5 percent. In terms of credit, financial institutions, fearing losses, may pull back on lending. This deprives companies of capital, and restrains growth.

Expect reform

While the current banking situation is far from rosy, it is perhaps too early to say the industry is in turmoil. Nevertheless, there are growing calls for regulators to take further action. “I am hesitant to conclude that the banking sector is unstable based on March 2023 events,” says Ms Barrage. “Nevertheless, it is clear that supervisory and regulatory reforms are being considered in the aftermath of these failures, including Basel III capital reforms, which were already underway.

“In the US, President Biden – through a Fact Sheet – has publicly ‘urged’ regulators to undertake a number of regulatory and supervisory reforms focused on large regional banks. The Federal Reserve and the FDIC have published their assessments of the root causes of SVB and Signature Bank’s failure, respectively. The FDIC has issued a report detailing its comprehensive review of the deposit insurance system, and also proposed a special assessment to cover the costs associated with protecting uninsured depositors following the failures of SVB and Signature Bank,” she adds.

As is often the case, and as seen in the wake of the 2007-08 financial crisis, regulatory change may be inevitable. “After every crisis, the regulators look afresh at the rules,” says Mr Donegan. “I expect to see changes to the way that alternative tier 1 bond instruments – a type of debt designed to absorb losses when a bank fails – are regulated. It does not seem right from a policy perspective that bondholders are wiped out ahead of equity, as happened on Credit Suisse. Either the regulation of the whole capital stack needs reform, to place these instruments behind equity in the hierarchy, or a new ‘no worse than equity’ principle needs to be introduced. Either way, the market needs clear rules on priority.”

For Ms Barrage, the potential regulatory impact on banks will depend on the approach policymakers decide to take. “Will they study the root causes detailed in the 1 May reports and craft sensible supervisory and regulatory reforms in response, or will they be guided by the broader goal of undoing Trump-era regulatory tailoring?” she asks. “We may see a blend of these approaches. It is too early to know. On the supervisory side, we expect to see proposals designed to compel early action by senior management, along with additional safeguards for rapidly growing banks. On the regulatory side, we expect changes to the capital framework, along with a requirement that additional institutions maintain limited levels of total loss-absorbing capacity in the form of long-term debt. Future regulations are also likely to tie incentive compensation to performance for risk management and controls, and it is possible that more institutions will be required to file resolution plans, both under the Dodd-Frank Act and directly with the FDIC.”

For the banking sector to prosper and support the global economy, governments and regulators will need to respond pragmatically to current volatility. Gaps in surveillance, supervision and regulation will need to be closed to maintain financial stability.

© Financier Worldwide

BY

Richard Summerfield