The latest events in the banking world involving first Silicon Valley Bank and later Credit Suisse demonstrates once again the importance of maintaining confidence in the financial system and the role that central banks, regulators, and resolution authorities play in managing systemic/contagion risks[i].
Potential Crisis number 1
Credit Suisse is one of the biggest banks in the world and in fact is designated as a global systemically important bank (by FINMA the Swiss regulator). It has a large portfolio of business including that of deposit taking, wealth management, investment banking and asset management operations. Assets under management as at 2022 was 540 billion Swiss francs and was even larger in prior periods.
A bank’s systemic importance depends on its size, interconnectedness with the financial system and the substitutability of the services provided. A failure of a GSIB can cause serious contagion to the financial system and the wider economy. In that regard, GSIB’s are subject to greater requirements than other banks. Additionally, Credit Suisse as a GSIB would have in place a recovery plan to deal with stress scenarios (such as a liquidity crisis).
Notwithstanding these requirements, even GSIBs from time to time fall into distress[ii] and it is how such a crisis is dealt with that is important. In the case of Credit Suisse, while it faced many issues in the past couple of years, its immediate issue is a liquidity challenge that has been addressed by the Swiss National Bank’s agreement to provide liquidity support of 54 billion Swiss francs, in its role as lender of last resort, and the Bank’s announcement to buy back some of its senior debt (likely part of its recovery plan).
This event is a great example of the importance of the role of central banks in maintaining confidence within the financial system and acting as lender of last resort.
However, if Credit Suisse is not able to maintain stability by these latest actions[iii], managing contagion risks may require the involvement of the resolution authority. FINMA, as resolution authority, has broad intervening powers to implement appropriate measures to protect the bank’s creditors and manage systemic risks. In accordance with the EU Recovery and Resolution Directive, resolution objectives include safeguarding financial stability and limiting taxpayer exposure to loss.
The Resolution Plan for Credit Suisse could involve restructuring the bank, selling off parts or the whole of the bank business in an orderly manner (in way that would avoid serious adverse effects to the economy), implementing a bail in strategy that would provide much needed equity, etc. FINMA could also take actions such as replacing management at Credit Suisse.
Potential Crisis number 2
The Credit Suisse calamity is very different from the one at Silicon Valley Bank (SVB), which ran into asset liability issues as a result of rising interest rates and increased customer withdrawals. Neither event is directly connected to each other. SVB also did not appear to have a litany of regulatory issues preceding its collapse (as reported in the case of Credit Suisse).
Furthermore, unlike Credit Suisse, Silicon Valley Bank was not a GSIB. However, it is not necessary for a bank to be designated as a SIFI for its failure to lead to contagion within the financial sector. The banking system is built upon maintaining confidence in order to avoid banks runs that could lead to a liquidity and consequently an insolvency crisis, spreading from one bank to another, particularly given its fractional reserve nature. Maintaining confidence to curb contagion is even more crucial than it was years ago, given the fact that withdrawals can now take place in a few minutes versus the physical long lines of previous bank runs[iv].
In the case of SVB, confidence was eroded when bond interests’ rates rose and the value of the long-term bonds held by the bank plummeted. This unstable position of the bank was further aggravated as a result of increased depositor withdrawals by crypto/ tech customers who were facing financial issues of their own. Prior to this event, SVB was rather profitable with $209.0bn in assets and $175.4 bn in total deposits as at December 2022[v].
To fulfil withdrawal obligations, the Bank was forced to sell assets at a severe loss resulting in an inability to raise sufficient funding to keep afloat. As a result, panic ensued, withdrawals increased and the risk of contagion to other banks in the sector appeared to be looming; particularly with the subsequent closure of another bank- Signature Bank. For example, shares of First Republic Bank dropped, raising questions, inter alia, over the stability of the bank and no doubt there were issues of confidence in respect of the local banking sector.
To manage contagion to the rest of the banking sector and maintain confidence, the FDIC (as resolution authority) and Federal Reserve (as the central bank) had to take some swift and immediate steps. The FDIC created a bridge bank (the National Bank of Santa Clara transferring all deposits and guaranteeing the deposits of all customers (whether insured or not). The Fed offered a Bank Term Funding Program to enable financial institutions to access loans to meet depositors’ obligations. This helped to manage systemic risks and avoid a serious banking crisis.
In the United Kingdom, swift action was also taken by the resolution authority to sell SVB’s UK business to HSBC, thereby protecting 6.7 billion pounds in deposits.
The failure of a bank does not necessarily result in a banking crisis. But the failure of a GSIB like Credit Suisse (that is so large and interconnected with the rest of the financial sector) or the failure of several banks could certainly trigger the spread of bank runs to other banks and thereby lead to a crisis[vi].
The failure of first Silvergate Bank, and subsequently SVB and Signature Bank had the potential to lead to a banking crisis, if the authorities had not stepped in to avoid further bank runs by ensuring availability of liquidity for all other financial institutions thereby guaranteeing confidence in the banking system. The change in interests’ rates on bonds is arguably one of the triggers for this calamity[vii], together with the already fragile crypto sector that these failed banks supported.
Conclusion
The above discussion demonstrates the fragility of the banking system and the importance of managing risks and maintaining confidence. It highlights the critical roles of the regulator and resolution authorities in mitigating risks and averting the collapse of the economy; and notes how critical it is to maintain trust and confidence in the financial system to avoid a crisis.
Notes
[i] The Financial Stability Board’s (FSB) definition of systemic risk refers to the risk that the failure of an institution would result in the disruption to the flow of financial services and impair the operation of the financial system and the real economy. Systemic risks may, inter alia, stem from a number of sources including asset price contagion, counterparty contagion, uncertainty of information contagion and/or irrational contagion.
[ii] There are many reasons an entity can fall into distress despite regulatory requirements. For example, even if a company has a significant capital buffer, poor management can lead to the capital being used up or assets becoming impaired despite regulatory oversight.
[iii] Financial Times has reported that the actions has not curbed the slump of share prices and talks are now underway for a possible merger of Credit Suisse with another bank. https://www.ft.com/content/5746165a-3a0c-42c7-9a2e-cb7cf5f33f46
[iv] Consider for example how much quicker the Northern Rock collapse could have happened.
[v] Information as reported by FDIC: https://www.fdic.gov/news/press-releases/2023/pr23016.html
[vi] The failure of banks could also have adverse effects on the payments system and other aspects of the economy. For example, the simultaneous selling of assets by many banks, prompted by in this case devaluing of assets held and even rumors, can lead to large declines in quite visible asset prices. Authors Gerard Caprio Jr. and Daniela Klingebiel: ‘Bank Insolvency: Bad Luck, Bad Policy, or Bad Banking?’ point out that “The possibility of contagion means that a single bank failure has not only a direct negative effect on GDP associated with the loss of the bank's profits and wages (as with any bankruptcy) but also an indirect and potentially larger effect to the extent that the bank failure leads to or is associated with other bank failures and the shutdown of the payments system. Widespread bank failure also can indirectly affect economic activity to the extent that bank closures lead to the drying up of information.”
[vii] It also highlights the importance of diversification of assets but that is for another discussion.