Banks under stress: will it be different this time?

Recent events in the international banking system bring back memories of the 2008 Lehman Brothers crisis and the global financial crisis that followed. In an already turbulent international financial environment, news of the collapse of three US banks and pressure on the Swiss banking giant, Credit Suissehave raised legitimate concerns about the possibility of another financial crisis. Are we really facing such a possibility?

As many analysts point out, the cases of Lehman Brothers and Silicon Valley Bank (SVB), the most important of the three failed US banks, are different. The Lehman Brothers crisis was the result of an unprecedented financial “bubble” bursting in the US housing market during a period of high liquidity, rampant financial innovation, and excessive relaxation of regulatory restrictions and supervisory controls.

On the other hand, SVB is a bank that has mainly funded startups in the global tech Mecca of Silicon Valley. This bank did not make aggressive investments. During the pandemic, he invested in government and other long-term bonds. The pressure faced by the technology sector in recent months and the rapid hike in interest rates by the US central bank to fight inflation have led to an outflow of deposits.

His losses were compounded by higher deposit rates he had to pay to keep his clients. In an attempt to cover her losses, she sold some of her bonds for a $1.8 billion loss. The loss announcement and his intention to cover the losses by issuing shares caused concern and caused panic and run on deposits as 96% of his deposits exceeded the $250,000 guarantee limit and were therefore at risk.

Despite the obvious differences, the recent episode shares important similarities with previous crises. One is the significant impact on the financial system of rapidly rising interest rates, especially after a long period of easy money.

A sharp rise in interest rates reduces the value of banks’ asset claims, be they loans that borrowers cannot repay at new higher interest rates (credit risk), as was the case in 2008, and could happen again as a result of the current rise in interest rates – whether they are bonds issued in a lower interest rate regime (interest rate risk), as was done in the past during the “savings and credit crisis” of the 1980s in the United States. In the second case, the “gap” formed during the assessment of claims turns into a loss when the bank needs to liquidate some of them, as happened with the SVB. Unrealized losses of this kind on US bank bonds were estimated at $620 billion at the end of 2022.

Another point concerns the excessive exposure of banking institutions to general risk. In the case of the 2008 crisis, it affected the US housing market. In the case of SVB, there was reliance on one business sector and type of business, which contributed to a very high level of uninsured deposits. If there are many other banks with these characteristics, then the potential for systemic risk increases significantly.

Finally, another important common element is the weakening of the regulatory framework before the crisis. In 2018, under pressure from the banking sector, the U.S. government, under the leadership of President Trump, began to relax some of the rules that affected mid-sized banks such as SVB. If this had not happened, it is quite possible that the problems of the SVB would have been identified much earlier, and we would not have reached its bankruptcy.

The aforementioned failures show that regulators have not learned everything they should from previous crises. On the other hand, it would be unfair not to admit that some of the lessons seem to have really been learned. Thus, despite its shortcomings, the regulatory framework is much stronger today than in the past, and banks are better capitalized. It is also clear that the competent authorities have understood that the response to such situations must be immediate, and aimed not only at solving any problem, but also at restoring a sense of confidence in the market, in order to avoid the risk of contagion of the crisis.

Addressing past failures is extremely important, as today the risks are higher and not only associated with the consequences of higher interest rates. An important new element is the speed with which the panic arose in the case of SVB and other US banks. Characteristically, the bank’s customers withdrew $42 billion in one day, which corresponds to a quarter of its deposits. As it became known, the panic intensified after a discussion on social networks, where some of the large clients urged the rest to leave the bank. It is clear that new technological opportunities accelerate development from the moment when even the slightest hint of a problem seeps into the financial institution.

Now no one can say for sure what will happen next. The authorities’ quick and decisive response appears to have prevented the spread of unrest for the time being, but markets remain nervous as it is not known which banks are vulnerable to the new interest rate conditions and to what extent. A new financing facility launched by the US central bank gives banks access to borrowed funds without having to sell their bonds at a loss. That eases the immediate pressure, but it doesn’t relieve them of having to pay for recently increased borrowing costs, which some analysts say could lead some of them into slow bankruptcy.

It is now clear that the financial system, despite the important reforms that followed the 2008 crisis, is not as safe as we thought, and that even medium-sized banks, which until recently were not considered systemic, could be the catalyst for a new crisis. . The authorities must pay more attention to the lessons of previous crises if they are to prevent a new one.

* Dimitris Katsikas – Associate Professor at EKPA, Chief Research Fellow at ELIAMEP