How to avoid a banking crisis: Lessons from recent bank failures

Bank failures: An economic nightmare or a wake-up call for reform? Read this blog post and learn from the lessons of the recent bank failures.

How to avoid a banking crisis: Lessons from recent bank failures
Photo by Etienne Martin / Unsplash

Imagine that you have a bank account with a lot of money in it. You trust your bank to keep your money safe and accessible. You also trust your bank to use your money wisely and profitably, by lending it to other people or businesses who need it.

But what if your bank suddenly fails?
What if your bank runs out of money and can’t pay you back?
What if your bank makes bad investments and loses all its capital?
What if your bank gets into trouble with the regulators or the law?

This is not just a hypothetical scenario. It actually happened to some banks in the United States and Switzerland earlier this year. These banks failed because they faced severe liquidity problems, meaning they didn’t have enough cash or assets that they could quickly convert into cash. They also had unsustainable business models, meaning they were not making enough profits or had too much risk.

These bank failures were very serious. They threatened to disrupt the financial system and cause losses for depositors, creditors, shareholders, and taxpayers. They also raised questions about the effectiveness of the current rules and tools that are supposed to prevent or manage such failures.

Fortunately, the authorities in both countries acted swiftly and decisively. They used their powers and resources to resolve the failing banks in an orderly manner. They also ensured that the critical functions of the banks continued, while minimizing the involvement of public funds.

But how did they do it? And what can we learn from their actions?

In this blog post, I will explain the main features of the bank failures and the strategies that were adopted by the authorities in the United States and Switzerland.

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The US bank failures: Signature Bank and Silicon Valley Bank

In early March 2023, two US regional banks failed: Signature Bank and Silicon Valley Bank.

These banks had a high proportion of uninsured deposits, meaning deposits that exceeded the limit covered by the federal deposit insurance fund. These deposits belonged mostly to wealthy individuals or businesses who trusted these banks for their specialized services or niche markets.

However, these banks faced a sudden loss of confidence from their depositors. Many depositors withdrew their money or moved it to other banks. This created a liquidity crisis for these banks, meaning they didn’t have enough cash or liquid assets to meet their obligations.

The Federal Deposit Insurance Corporation (FDIC), which is the agency responsible for insuring deposits and resolving failed banks in the United States, took both banks into receivership. This means that the FDIC took control of these banks and their assets.

The FDIC then created temporary bridge banks, which are new entities that take over some or all of the operations of the failed banks. The bridge banks continued to serve the customers of the failed banks until they were sold to other buyers in the market.

This resolution strategy was possible only because the US authorities invoked a “systemic risk exception”. This is a special provision that allows them to override the usual limits on how much money the FDIC can use to finance a resolution. With this exception, the FDIC was able to cover all deposits, including those that were not insured. This prevented panic among depositors and avoided further contagion in the banking sector.

However, this exception also meant that some public funds were used to support these resolutions. The FDIC had to borrow money from the US Treasury to cover its losses. The FDIC also imposed losses on some creditors of these banks, such as shareholders and certain unsecured debtholders. These creditors did not receive any compensation for their claims.

The Swiss bank failure: Credit Suisse

A week after the US bank failures, another major bank failure occurred in Switzerland: Credit Suisse.

Credit Suisse is one of the largest and most important banks in Switzerland and globally. It provides various financial services to individuals, corporations, governments, and institutions around the world.

Credit Suisse faced an acute liquidity crisis after it suffered huge losses from its involvement in two scandals: one related to Archegos Capital Management, a hedge fund that collapsed after making risky bets on stocks; and another related to Greensill Capital, a supply chain finance company that went bankrupt after being accused of fraud.

These scandals damaged the reputation and credibility of Credit Suisse. Many customers and investors lost trust in the bank and withdrew their money or reduced their exposure. This created a liquidity crunch for the bank, meaning it didn’t have enough cash or liquid assets to meet its obligations.

The Swiss authorities decided to intervene to save Credit Suisse. They announced that UBS, another large Swiss bank, would merge with Credit Suisse and provide liquidity support for this process. They described this as a “commercial transaction”, meaning that it was based on market conditions and mutual agreement.

However, this transaction was not a normal merger. It was supported by special decrees enacted by the Swiss government using emergency powers. These decrees allowed the Swiss National Bank, which is the central bank of Switzerland, to provide liquidity support to UBS and Credit Suisse. This support was not fully collateralized, meaning that the central bank took some risk in lending money to these banks.

The transaction also involved the write-down, or reduction, of all the outstanding Additional Tier 1 (AT1) capital instruments issued by Credit Suisse. These instruments are a type of hybrid debt that can be converted into equity or written off in case of financial distress. They are supposed to absorb losses and protect other creditors and taxpayers from bearing the costs of a bank failure.

By writing down these instruments, the authorities reduced the amount of public funds that were needed to support the merger. They also imposed losses on the holders of these instruments, who were mostly institutional investors such as hedge funds or pension funds.

However, this writedown also overturned the expected hierarchy of creditor losses that would have applied if Credit Suisse had been put into resolution. Resolution is a legal process that allows authorities to restructure or liquidate a failing bank in an orderly manner. In resolution, creditors are supposed to be treated according to their seniority, meaning that those with lower priority should bear losses before those with higher priority.

In this case, the holders of AT1 instruments were treated as if they had lower priority than the shareholders of Credit Suisse. This was contrary to the contractual terms of these instruments and the resolution framework in Switzerland. This also had significant, but relatively short-lived, repercussions in the market for AT1 instruments. The prices of these instruments dropped sharply after the announcement of the writedown, reflecting the increased uncertainty and risk for investors.

What can we learn from these bank failures?

These cases demonstrate that Switzerland and the United States had effective crisis management frameworks that enabled them to deal with a range of cases. They were well prepared and had sufficient powers, tools, and funds to manage the failing banks in an orderly manner. They also had enough flexibility to adapt their responses to the prevailing conditions.

However, these cases also show that there is room for improvement in some aspects of these frameworks or their implementation. Here are some areas that I think deserve more attention:

  • Banks’ loss-absorbing capacity and the credibility of bail-in as a resolution tool. Bail-in is a mechanism that allows authorities to write down or convert into equity some or all of the liabilities of a failing bank. This reduces the value of these liabilities and increases the value of equity. This way, creditors share the losses and provide new capital for the bank. Bail-in is supposed to reduce the need for public funds and make banks more resilient.

However, bail-in was not fully used in these cases. In the US case, only some creditors were bailed in, while others were protected by public funds. In the Swiss case, bail-in was not used at all, as the authorities opted for a merger instead of a resolution.

This suggests that banks should have more liabilities that can absorb losses in resolution. Currently, only the largest banks are required to maintain minimum amounts of such liabilities. Other banks should also have enough loss-absorbing capacity to make bail-in feasible and credible.

  • The writedown of hybrid capital instruments. Hybrid capital instruments are a type of debt that can be converted into equity or written off in case of financial distress. They are supposed to provide an additional layer of protection for other creditors and taxpayers.

However, these instruments are complex and vary across jurisdictions and contracts. Many market participants may not fully understand how they work and when they can be triggered. This can create confusion and uncertainty in times of crisis.

Therefore, there is a need for more disclosure and education about these instruments. Investors should be aware of their risks and rewards. Authorities should also communicate clearly their expectations and actions regarding these instruments.

  • The cross-border application of resolution tools. Many banks operate across borders and have subsidiaries or branches in different countries. When such banks fail, their resolution may affect other jurisdictions and authorities.

Therefore, authorities need to cooperate and coordinate with each other when planning and executing resolution actions. They also need to ensure that their resolution powers and tools can be applied across borders effectively and consistently.

This requires mutual trust, understanding, and respect among authorities. It also requires clear and robust legal frameworks that can accommodate different legal systems and cultures.

  • The use of public funds in resolution. The use of public funds in resolution is a sensitive issue. It can create moral hazard, meaning that it can encourage banks to take more risks if they expect to be bailed out by the government. It can also create political backlash if taxpayers feel that they are paying for the mistakes of banks.

Therefore, authorities should strive to minimize the use of public funds in resolution. They should also ensure that any use of public funds is transparent, accountable, and justified by the public interest.

These are just some of the lessons that we can learn from these bank failures. There are many more lessons to be learned, and many more challenges to be addressed. But I believe that with the right mindset, tools, and efforts, we can make our banking system safer, stronger, and more resilient.

In conclusion, here are five key takeaways from this blog post:

  1. Bank failures can happen even in advanced economies like the United States and Switzerland. They can be caused by a variety of factors, including liquidity problems, unsustainable business models, loss of confidence, or scandals.
  2. Authorities have effective crisis management frameworks that enable them to deal with bank failures in an orderly manner. These frameworks include powers, tools, and funds for resolution; loss-absorbing capacity requirements for banks; and cross-border cooperation mechanisms.
  3. Bail-in is a powerful resolution tool that can reduce the need for public funds and make banks more resilient. However, it needs to be credible and feasible, which requires banks to have enough loss-absorbing capacity.
  4. Hybrid capital instruments can provide an additional layer of protection for other creditors and taxpayers. However, they are complex and vary across jurisdictions and contracts. Therefore, there is a need for more disclosure and education about these instruments.
  5. The use of public funds in resolution is a sensitive issue that requires transparency, accountability, and justification by the public interest.

I hope you found this blog post informative and engaging. If you have any questions or comments, please feel free to share them below. Thank you for reading!

P.S. Did you know that the banking sector is often compared to the human circulatory system? Just as our heart pumps blood to every part of our body, banks circulate money throughout the economy. If you were to compare a bank to a part of the human body, which would it be and why? Share your thoughts in the comments below!

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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