Financial déjà vu

Jonathan Watson, IBA Finance CorrespondentMonday 22 May 2023

The banking sector is in turmoil once again. Global Insight assesses the similarities to the 2008 global financial crisis and the lessons learned since then.

The collapse of Silicon Valley Bank (SVB), Signature Bank and the last-minute rescue of First Republic by JPMorgan, as well as UBS’ takeover of Credit Suisse, has rocked the global banking system.

SVB set the ball rolling in early March when it was shut down by Californian regulators following a bank run. This prompted customers to begin withdrawing money from Signature Bank, another US regional institution. Regulators feared continued contagion in the banking sector and closed Signature on 12 March in a bid to contain the panic. The much larger Credit Suisse then saw its shares plummet by 30 per cent before UBS stepped in to agree a historic $3.25bn deal, brokered by the Swiss government, in mid-March.

This series of shocks was followed by an eerie calm, leading some to conclude that the worst was over. But a couple of weeks later, there was another collapse. This time, it was First Republic, most of which is to be acquired by JPMorgan Chase after US regulators put together an overnight deal. First Republic took SVB’s place as the second-biggest bank failure, in terms of assets, in US history.

Echoes of 2008

To anyone who lived through the 2008 financial crisis, all this sounds horribly familiar. Is another global meltdown on the cards? Not according to JPMorgan’s Chief Executive Officer, Jamie Dimon. He told a conference call in early May that the US banking system was ‘extraordinarily sound’. His company’s takeover of First Republic means the sector is ‘getting near the end’ of the spate of bank collapses and will ‘hopefully help stabilise everything’.

Dirk Bliesener, Senior Vice-Chair of the IBA Banking Law Committee and a partner at German law firm Hengeler Mueller, is another who’s not predicting a huge crisis. ‘The banks are much more resilient now in terms of capital’, he says. ‘They have shown huge profits over the past year and a lot of dividends are being paid. Although regulators and supervisors are taking a very conservative stance in terms of retaining capital for the future, I think the banks are more resilient than they were in 2007–8.’

DeAnne Julius is a senior adviser to the international affairs think tank Chatham House and a Distinguished Fellow in its Global Economy and Finance programme. ‘There’s a heightened sense of nervousness, but the preconditions for the beginning of a big financial crisis are not there’, she says. ‘SVB went under for very specific reasons that don’t apply to many other banks. And with Credit Suisse, with hindsight one can see that there were many reasons for investors and bondholders to be much more worried than they were.’ However, the current crisis still has some way to go. ‘It’s not yet entirely over because there are still a lot of uncertainties’, says Bliesener.

‘It’s too early to tell if this banking crisis will evolve further in the future, but past experience suggests it will, particularly if it helps to cause a credit crunch or has significant wider economic impacts’, says Jesse Griffiths, CEO of the Finance Innovation Lab, a UK charity that ‘works for a financial system that serves people and planet’.

What’s really unique about the recent collapses is how quickly they occurred, says Shane Pearlman, North American Regional Forum Liaison Officer for the IBA Banking Law Committee and a partner at Canadian law firm Borden Ladner Gervais. ‘This can, in part, be traced back to the way information can spread like wildfire in the social media age and the speed and immediacy of the electronic banking system’, he adds. ‘It no longer takes weeks or months for fears about the failure of a bank to circulate. Similarly, long gone are the days of a customer waiting to go to their bank and standing in line at their branch to withdraw their deposits.’

This heightens the risk of a ‘domino effect’ in the banking sector. When one bank fails, others are likely to follow. However, ‘while new issues have recently emerged with smaller, regional banks that were typically more heavily dependent on uninsured deposits, my view is that the banking system generally remains strong and vibrant’, says Pearlman.

Perhaps there’s no need to worry, but some statistics do look ominous. Three of the four biggest bank failures in history have occurred in 2023 (See box: Top ten US bank failures) and it’s still only May. It seems likely that there will be more before the end of 2023. In addition, the combined assets of the three US banks that have collapsed this year eclipse the total assets of all banks that failed in 2008 by about $180bn.

A failure of regulation (again)

The role of regulators has once again been in the spotlight. The current turmoil, says Griffiths, ‘serves as a reminder that financial regulation should be strong enough to prevent such crises emerging and resolve them quickly if they do – and the system has failed on both counts in this case’.

The US central bank, the Federal Reserve (the ‘Fed’), admitted in its own review of the collapse of SVB that it had failed to act with ‘sufficient force and urgency’ in its oversight of the bank. Michael Barr, the Fed’s Vice-Chair for Supervision, led the review. He said the lesson of SVB’s demise was that the central bank should tighten its rules. ‘Federal Reserve supervisors failed to take forceful enough action’, he said, highlighting regulatory standards that were ‘too low’, supervision that lacked any sense of urgency and risks to the wider system posed by difficulties at a mid-size bank that the Fed’s policies had missed.

The Federal Deposit Insurance Corporation issued a separate report on Signature Bank’s failure. In this report, it admitted it was slow to escalate issues it identified with the lender’s management.

According to its own review, the Fed’s decision to take a looser approach to the oversight of small- and medium-sized banks, a response to a law passed by Congress in 2018 – the Economic Growth, Regulatory Relief, and Consumer Protection Act – was a key part of the problem. That legislation (See box: Is deregulation to blame?) eased oversight of all banks with assets of less than $250bn and exempted small community banks from a host of stricter rules and oversight established by the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010. Dodd-Frank, of course, was the central pillar of the US regulatory response to the 2008 global financial crisis.

Then-US President Donald Trump criticised Dodd-Frank and ‘job-killing regulations’ when signing the Economic Growth, Regulatory Relief, and Consumer Protection Act in 2018. Referring to those who had supported the bill, he said: ‘This is all about the Dodd-Frank disaster. And they fixed it, or at least have gone a long way toward fixing it.’

Dennis Kelleher is the CEO of Better Markets, a US-based non-profit organisation that campaigns for financial reform. According to him, the Fed’s report ‘in effect says that if you take the cops off the city streets in a high crime neighborhood, then there’s going to be lots more lawbreaking’. That’s essentially what happened in the banking and financial industries, beginning in 2017 and throughout the Trump administration, Kelleher says. ‘Deregulation and weakened supervision incentivised financiers to take more risks which inevitably led to recklessness, failures, and crisis’, he adds.

In a separate report, the US Government Accountability Office said that while the banks were brought down primarily by a combination of risky strategies and weak risk management, Fed officials also moved too slowly once problems were uncovered.

The regulations themselves are often to blame as well as regulators, says Griffiths. ‘Global banking regulations failed to highlight the weakness of Credit Suisse or prevent it from becoming the first major global bank to fall in this crisis’, he says. ‘In fact, according to the enhanced rules for what the Bank for International Settlements [the global organisation of central banks] calls globally systemically important banks, Credit Suisse looked just fine.’

These banks had to hold even higher capital buffers than normal banks, which Credit Suisse did. ‘Just days before they intervened, Swiss regulators were insisting that the capital and liquidity positions of Credit Suisse were strong’, says Griffiths. ‘They may have been right about this, but they were wrong to suggest that this made it safe.’

European contagion

European banks look more secure than those in the US for the time being. This is primarily because they tend to be bigger and more tightly regulated. The UBS/Credit Suisse deal, however, raised several uncomfortable issues. In their haste to get a deal done before the markets opened, Swiss regulators decided to wipe out $17bn of Credit Suisse’s additional tier 1 (AT1) capital debt under the terms of its takeover by UBS. FINMA, the Swiss regulator, reportedly saw the move as bolstering the bank’s capital.

That decision ‘put the spotlight on how much of a bank’s funding is raised through those AT1 bonds, which were a new financial technology thought up after the global financial crisis’, says Chatham House’s Julius. ‘The idea was that they would be a new subset of borrowings that stood between normal bonds that banks have always issued to raise money and shareholders. If a bank began to be insolvent or was facing bankruptcy, then bonds wouldn’t be treated with the same seriousness as a normal bond.’

The Swiss deal highlighted the risks of investing in AT1s, forcing European regulators into action to stop a market rout. The European Central Bank, the Single Resolution Board (SRB) and the European Banking Authority all had to affirm that Eurozone banks would not suffer the same fate; AT1 bondholders would only suffer losses after shareholders have been wiped out.

‘I am not quite sure why the AT1 bonds have been written to zero in the Credit Suisse deal while the equity holders are saved, and bonuses will still be paid’, says Vasso Ioannidou, a Professor of Finance at Bayes Business School in the UK. ‘Such moves clearly raise the risk in bond markets with clear possible adverse effects on other countries.’

It was mentioned in the terms and conditions of the bond that a write-off may be triggered by the authorities, although Common Equity Tier 1 is not. ‘That provision existed, but many people were not aware of it, also because the major debates on resolution date back several years’, says Bliesener. ‘Now we have to find out whether the authorities lived up to the choreography foreseen in the terms and conditions.’

The deal has had a significant impact on the market. ‘Currently AT1, for any bank and including in many other jurisdictions, is not sellable at acceptable conditions’, says Bliesener. ‘It will take some time to come back, but it will come back, because there is pressure to create this form of capital.’

‘The AT1 instruments issued by Credit Suisse contractually provide that they will be completely written down in a “Viability Event”, in particular if extraordinary government support is granted’, FINMA told Global Insight in a statement. ‘As Credit Suisse was granted extraordinary liquidity assistance loans secured by a federal default guarantee on 19 March 2023, these contractual conditions were met for the AT1 instruments issued by the bank.’

The regulator’s statement also says that an emergency ordinance enacted on 19 March authorised FINMA to order the borrower and the financial group to write down AT1 capital. ‘Based on the contractual agreements and the Emergency Ordinance, FINMA instructed Credit Suisse to write down the AT1 bonds’, reads the statement.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, US, 19 April 2023. REUTERS/Brendan McDermid

The Swiss Federal Administrative Court said it had, as of 4 May, registered around 150 appeals – representing between 2,000 and 2,500 individual appellants – resulting from FINMA’s decision on the AT1 bonds. Investors representing up to a third of the $17bn in AT1s issued by Credit Suisse have now launched legal action. FINMA did not comment on the litigation when approached by Global Insight.

Bliesener does not believe that such litigation will amount to much. ‘You may criticise the way the authorities acted from a consumer perspective, or market perspective, but they did act within the reach of their authority’, he says. However, the outcome of any litigation may depend on the jurisdiction where it takes place. ‘It’s less foreseeable what the outcome would be in the US’, says Bliesener. ‘But in the Swiss or European courts, I don’t think there’s a lot of chance of winning these cases.’

The issue of resolution planning also reared its ugly head. Resolution plans, more often known as ‘living wills’, set out a bank’s plan for quick and orderly dissolution if it fails. Dodd-Frank requires large US banks and certain other companies to have such plans. The Swiss authorities, however, decided that Credit Suisse’s living will was unworkable when it needed a rescue takeover. Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank, said that relying on living wills when a bank is imploding was not an option in a ‘extremely fragile environment’.

If that is the case, it raises the question as to what living wills are for, and why should banks spend millions developing them? There seems to be no easy answer to this. ‘It’s very political, in that individual countries shy away from using living wills because they are untested, and they may have repercussions that are undesirable’, says Bliesener.

New rules for banks in crisis

The European Commission recently unveiled a new set of rules designed to make it easier to transfer depositors’ cash to healthy institutions from troubled lenders, or to wind down a problem bank without drawing on taxpayers’ money. As in the US, there’s a focus on stopping taxpayers’ money from being used to save ailing banks – as happened during the 2007–8 financial crisis. Brussels expects that the new rules will make it more difficult for governments to hand over ‘precautionary’ funding to lenders who are in trouble. This closes a loophole that Italy used in 2017 to provide billions of euros of taxpayers’ money to Banca Monte dei Paschi di Siena.

The Commission wants more EU Member States to go to the SRB, which was created in 2015. The SRB can impose losses on shareholders and junior bondholders of failing lenders but has only dealt with two failing banks so far. It oversaw the insolvency filing of the Austrian subsidiary of Russia’s Sberbank in 2022 after EU sanctions were imposed on its parent company and transferred Spain’s Banco Popular to its larger rival Banco Santander for €1 in 2017.

The new rules have been in the pipeline for some time, since before the recent banking turmoil, and could face stiff opposition from EU Member States. Christian Sewing, the CEO of Deutsche Bank, has already rejected them. At the Association of German Banks’ annual press conference in mid-April, he said making resolution the standard instrument for bank crisis management ‘would be at the expense of our well-functioning national deposit guarantee scheme’. He added that tightening of banking regulations ‘will lead to further activities migrating to the so-called shadow banking sector, which has already grown considerably in the wake of the financial crisis’.

‘The problem is that, although you may tighten the net of regulation of resolution cases, and the possibility of extraordinary public support, when it comes to a crisis for very big banks, all these organisations, such as the SRB and its fund, will not be sufficient to meet the needs in liquidity and capital’, says Bliesener. Unfortunately, he adds, recent bank failures have shown that there’s ‘no very firm political will to enforce these rules in a banking crisis which is very large and may affect the real economy with a very uncertain outcome’.

The political scene hates these uncertainties and would rather use taxpayer money and taxpayer guarantees. ‘We've been fighting for 15 years to address that since the great financial crisis’, Bliesener says. ‘We have not been successful. I think all this means that the European Commission's latest attempts to tighten the net on resolution will not actually be successful when it comes to large failures.’

Nevertheless, it is inevitable that the current crisis will lead to more regulation. ‘You can regulate and regulate, but banking, by its nature, involves a certain amount of risk’, says Julius. ‘Short of going to central bank money, which then means the central bank controls everything, I’m not sure that there is an end in sight to having the occasional blow up.’

Jonathan Watson is a journalist specialising in European business, legal and regulatory developments. He can be contacted at jonathan.watson@yahoo.co.uk

Image credit: HJBC/AdobeStock.com