Banking crisis wake-up call: How to navigate failures and strengthen regulations
THE GOVERNMENTS OF ADVANCED ECONOMIES NEED TO REVIEW BOTH THE MONETARY AND FISCAL SUPPORT AND SHOULD SLOWLY WITHDRAW IT.
In less than two weeks, three US banks, Silvergate, SVB, and Signature Bank, and a big global lender like Credit Suisse collapsed. While the fear of a full-blown financial crisis seems unlikely, concerns over the strength of financial institutions are imminent. Although the global financial crisis of 2007 took the markets by surprise and preparedness was minimal, the current crisis is limited to institutions with limited impact on related institutions and quick response by regulators. However, two things become important now. Firstly, to understand the gaps in regulation that led to the crisis and secondly, strengthening the regulations for the future.
The widespread belief is that the collapse of SVB in the US, which caught the attention of the markets towards the underlying crisis, was a result of rising interest rates, a medicine that the Fed has been administering to the economy to counter the rising inflation, which was an unforeseen consequence of large fiscal support in terms of payouts that the government has been giving to businesses. However, closer analysis suggests that prolonged Quantitative Easing (QE) pursued by the Federal Reserve during the Covid period caused a huge jump in uninsured demand deposits in the banks. As a result of massive deposits, banks had to increase their balance sheet and park excess liquidity in mortgage-based securities and other assets. Once the Fed started withdrawing QE and increasing policy rates, the uninsured depositors began withdrawing money. This phenomenon has been analysed in detail in the new working paper titled (Liquidity Dependence And The Waxing And Waning Of Central Bank Balance Sheets).
The governments of advanced economies need to review both the monetary and fiscal support and should slowly withdraw it. Though it may hurt people initially, in the long run, both people and the economy benefit. Take the example of India, which resisted the temptation of loosening fiscal and monetary policy, but rather followed the targeted approach of providing fiscal support, developing a national monetization and privatisation pipeline plan, and streamlining the tax regime. In contrast, the American approach to keeping lower interest rates and injecting money to support businesses during Covid resulted in a double whammy of soaring inflation coupled with higher interest rates. The US federal government spent $6.27 trillion in the financial year 2022, which was equal to 25% of the total gross domestic product, whereas India’s value was 11.13%. To give context, the world average in 2021 based on 154
countries is 16.83 percent. Hence, the larger policy approach of India has been a fair approach, keeping the economy swimming and sailing well. However, it is only rational to learn from what’s happening around the world.
One of the issues with SVB was that the bank fatefully invested in long-term bonds, consisting of rich proceeds from SPACS or IPOS or bloated VC funds. That is usually a safe bet for those banks/companies that aim to get a better rating. After all, what could be safer than American government bonds? But now, experience shows that the step to stability and success is in “diversification”. The key to insulation from systemic challenges is in keeping portfolios as diversified
as possible.
Credit Suisse is a classic case of losing life for protecting one’s pride. While the bank has been in all kinds of trouble since the Global Financial Crisis 2007, instead of letting it fail and leaving the market forces to make a course correction, it was kept on life support since it was considered too big to fail. Only to force another healthy bank to take over its liabilities and debt when the situation went out of control.
Both SVB and Credit Suisse prove that regulations alone are not a panacea for all the problems. Post Global Financial Crisis of 2008, reforms focused on improving the quantity, quality, and timeliness of loss-absorbing resources supporting financial stability but allowed banks to maintain their autonomy. The macroprudential framework focused on identifying signs of financial imbalances in a systemic event and ensured that loss-absorbing resources matched institutions’ systemic footprint. But how often these exercises are carried out internally, how accurate the data is, and how diversified the portfolios are, are aspects that only the board of directors can assess. Shareholders of the banks must play a key role in exercising oversight. The Dodd-frank Act, instituted after the 2007-08 financial crisis, mandated banks to perform stress tests; however, scenarios designed for performing the stress test didn’t include stagflation (inflation rising while the growth rate dwindles). Central banks usually go for rate hikes in stagflationary scenarios despite the lowering growth rate.
Sovereign actions taken during such crises usually have long-term effects. With UBS and Credit Suisse merging, there is a complete wipe-out of competition. Consumers will face an impact in the long run. The decision to prioritise shareholders over unsecured bondholders is likely to impact future foreign investment in the country. In the future, investors will be reluctant to invest in bonds, which may face lower ratings. The risk and reward of equity and debt are designed so that shareholders do not use corporations as vehicles for market abuse, and the confidence of investors, including unsecured creditors, remains firm. There will be no capital market without people’s confidence!
Coming to the larger question, how should governments handle bank failures? Well, bank failures are the most complex types of insolvency situations to handle. It is an area where free market theories are put to rest, and experts have not been able to come to a consensus. After all, there is high information asymmetry leading to cyclical market failure. While the focus of most regulations is to save banks for the sake of depositors and outside investors, the approach adopted in Credit Suisse is antithetical to this. The government should allow banks to fail. The market should only ease the acquisition of such failing banks, incentivizing market players to come forward and buy the stressed banks. Any bailout should be avoided, as the cost of a bailout outweighs the benefits of a bailout in the medium to long term.
There should be some mechanism to handle banking crises, and the broader theme of that mechanism should revolve around saving depositors and exposing shareholders and employees to the vagaries of market forces. It may include introducing a new deposit insurance scheme, and the government can insure up to a certain amount and let HNI depositors insure any amount above that.
With the advent of newage technologies and economic activities becoming more complex, the regulation of banking and financial institutions needs sharp focus and innovative methodology. The present crisis provides opportunities for regulators to plug loopholes and become more proactive rather than reactive.