Financial crises begin in the United States: 2007 by the misuse of securitization technology and the dynamic business model based on it, make loans, sell and forget.
In 2023 it will be the US regional banks that will be the first to fail in the banking business – the maturity, lot size and risk transformation. It is not about credit risks that deteriorate macroeconomically due to a deep recession or in the specific sector due to structural problems and justify a need for write-downs. It is about the management of interest rate risk and thus about the assessment of monetary policy.
The timing of the banking problems and the extent of the uncertainty are surprising insofar as the central banks did not just start raising interest rates yesterday.
Since March 2022, the Fed has raised interest rates by 475 basis points; the Bank of England by 415 basis points since December 2021 and the ECB by 350 basis points since July 2022.
Differences in inflationary pressure and in the monetary policy interpretation of the causes of inflation explain the diverging time paths. Ultimately, however, it has been clear since the end of 2021 that the period of expansive monetary policy would be over for the time being, albeit after twenty years of getting used to low interest rates.
If investors in the US withdrew half of the unsecured deposits, the existence of 190 US banks would be threatened
Silicon Valley Bank, now being acquired by First Citizens Bank, is ranked 16th in size in the USA. Not only was it regionally limited, but it was also highly specialized in its industry. This requires particularly good and comprehensive risk management, since internally there are fewer possibilities for compensating for the handling of the risks taken.
However, medium-sized banks (up to at least 250 billion US dollars in assets instead of the previous 50 billion US dollars) were exempted from the tightened regulations after the financial crisis in 2017 under Trump with the “Financial Choice Act”.
This time, investors are not concerned with suspiciously suspecting an inscrutable network of bank balance sheets, but rather with asking how their bank could have managed the risk of interest rate changes, in view of the principle of interest rate policy synchronization.
US economists have calculated what it would mean if half of the unsecured deposits (more than 250,000 US dollars) were then deducted: 190 banks (out of a total of around 4000 institutions in the USA) were threatened existentially by impairment risks.
The central banks should refrain from excessive interest rate policy
What needs to be done? In the short term, the various players in financial supervision should join forces and intensify exchanges in order to be prepared to organize bank stabilization over a weekend.
The living wills of the banks do not seem to help, there is simply no time for the palliative care unit. Macroprudential supervision (of the entire financial system) must be strengthened.
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The central banks should refrain from excessive interest rate policy and make transparent what has been achieved in the fight against inflation and what still needs to be considered. Measured against this, the speed and extent of the interest rate hikes can be clearly moderated. For the ECB, for example, its inflation forecasts (3.4 percent in 2024 and 2.3 percent in 2025) indicate that the pressure to raise interest rates is easing.
Switzerland remains challenged: UBS’s balance sheet total of around 1.5 trillion euros is now twice as large as the country’s gross domestic product. In the event of difficulties, Switzerland will not be able to save the bank.
So there is no way around making this bank smaller or even dismantling it in an orderly manner. Or do you want to hope for others, for example for help from the euro zone?
Banks need to restructure their equity
In order to prevent future crises, the equity capital regulation for banks should be further developed. This affects the preference for government bonds.
In general, the finely tuned, risk-adequate calibration of capital backing loses its effectiveness if banks are not provided with unlimited risk-absorbing capital.
It would also be worth considering whether the proposal for a clearly defined liability cascade including bail-in bonds, as laid out in the Liikanen report, might not be helpful. This would increase the banks’ ability to react in a crisis.
Deviating from the usual hierarchy of liability (first shareholders, then creditors) as in the case of Credit Suisse is very problematic. The ECB’s commitment not to do this in the euro area must be followed. Because the same applies here: The suspicions of investors should not be aroused any further.
The author: Michael Hüther is Director of the German Economic Institute (IW).
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