What lessons can be drawn from recent events in the banking sector?

Tue 11 Apr 2023

In recent weeks, we have witnessed the successive bankruptcies of three banks in the United States, as well as the hasty takeover of Credit Suisse by UBS. This chain of events inevitably calls into question whether this trajectory echoes the leadup to the financial crisis of 2008. 

In reality, whilst these crises have stark similarities, notably regarding the timing of the events, they are nonetheless clearly distinct from one another and derive from different problems. Yet, some lessons still apply across the board.

The aforementioned crises were caused or aggravated by internal governance problems, and they cast doubt on the willingness, as well as the capacity, of the various control bodies and supervisors to intervene in a rapid and efficient manner. Further, they all underline the determining role of modern means of communication.

Better governance needed

Banks, like all companies, need governance appropriate for the risks incurred.

The head of banking supervision at the FED indicated during his recent hearing at the American Congress that Silicon Valley bank -SVB- was “a textbook case”. Upon analysis, the head of risk had left the institution and had not been replaced for several months. The liabilities were mostly made up of deposits that were not divided and were additionally concentrated by sector. However, they did have the typical feature of deposits whereby they were due at any time. The amount of these deposits had grown very rapidly without any concern from management or any of the control systems. These amounts had been invested in long-term government bonds, exposing the bank to liquidity and transformation risk on the one hand, and to interest rate risk on the other. These assets were not recorded in the accounts at market value. Consequently, the establishment was brutally confronted with an important and unexpected loss when it had to sell these portfolios in a hurry. Their value had considerably decreased because of the rapid rise in interest rates when they faced massive withdrawals of funds.

The case of Credit Suisse also raises questions about governance. Indeed, how could an institution of this size ignore or tolerate risk-taking when the amount was clearly excessive in relation to its equity capital? Much has been written about the exposures to the Archegos and Greensill groups and it is clear that the internal warning mechanisms did not function properly. Traditionally, any commitment must pass through several stages:

• It must comply with the risk appetite of the institution, which is defined annually and reviewed by the Executive Board and the Board of Directors;
• It must be monitored regularly by the accounting teams and the risk management department;
• It must be reviewed by the internal control bodies and the statutory auditors.

We can question why this institution and its managers ignored these very basic risks for so long: why did the traditional risk indicators in banks not work? How could the management and board of directors ignore such exposures? How could the auditors not highlight these risks? Why were the supervisory mechanisms, the last line of defense, not alerted?

These two cases highlight the need to strengthen governance within credit institutions.

More reactive control mechanisms

Beyond internal governance, two external control systems have a role to play in the assessment of risk taking. On the one hand, the statutory auditors must ensure that the company’s accounts reflect its financial situation, and, in the case of a credit institution, the banking supervisors, who control that the risks incurred are correctly identified, covered and are the subject of appropriate risk information. The latter are responsible for ensuring that risks are properly assessed and, as a last resort, that they are covered by equity capital. To do this, a whole series of ratios, which were very severely reinforced following the 2008 financial crisis, must be respected at all times by the banks. In addition, supervisors ask institutions subject to their control to “stress test” their risk exposures before verifying that, in dynamic terms, the institution can resist a worsening of its financial situation.

The aforementioned cases correspond to two different situations. Like other American institutions, SVB had benefited from a relaxation of banking regulations in 2018. This was when it had been decided that institutions with a balance sheet total of less than $250 billion would not have to comply with all the restrictive prudential standards, especially the monitoring of liquidity and transformation risks, the interest rate risk on the traditional banking book and the stress tests, for which the threshold was previously $100 billion. The problem with this is the scope of regulation and supervision rather than its effectiveness.

The case of Credit Suisse is disparate; as a systemic banking institution, it was among the institutions subject to a normally very tight control insofar as the systemic character underlined the risk of contagion that its possible disappearance was likely to generate. It is undoubtedly the fear of a possible contagion that led the various Swiss authorities (supervisor, Central Bank, Minister of Finance) to precipitate the buyout by UBS. Indeed, before this takeover, Credit Suisse was apparently solvent and liquid, so it is not a question of a resolution, but of a precipitated takeover under the strong impulse, apparently, of the public authorities. Beyond the fact that a certain number of risk-taking could have been possible without prior intervention of the supervisors, the subject of the resolvability of systemic establishments and the effectiveness of the measures imposed on them is raised.

Nevertheless, the efficiency of the different control bodies, auditors, and supervisors, must be improved in order to reinforce the ecosystem in which financial institutions evolve. A reactive supervision, intrusive in the right way, capable of identifying risks and not satisfied with administrative reports, is a factor of financial stability. 

Better consider modern communication methods

This new environment that has borne these crises differs to previous ones. It was possible for the first time to observe that modern modes of communication, and particularly social networks, played a significant role. It was allegedly a tweet that triggered massive reactions of withdrawal of deposits in the case of SVB, amplifying the liquidity crisis. It is also a statement that was obviously badly “managed” which created a “market accident” on a bank already made very fragile by a succession of crises. These new means of communication can thus have two equally damaging effects: the first of which encompasses spreading false information which is then rapidly propagated, and the second which constitutes giving an unanticipated magnitude to real facts. Both phenomena are able to create liquidity crises likely to threaten the very existence of banks whose functioning is based on trust, especially in the case of “retail” establishments financed via deposits due at any time. In the current climate, reflection is necessary to better consider these phenomena: mechanisms of the “circuit breaker” type could be envisaged to stop all transactions and avoid unfounded liquidity crises.