The banking crisis reveals the failure of the regulators

Trust is the beginning of everything. What sounds like a cheap advertising slogan or at best a platitude is a bitter reality in the banking world. If people think a bank has a problem, the bank gets one. Deutsche Bank also had to experience this these days, whose shares had to experience dizzying swings on the stock exchanges that were unworthy of a Dax group.

It is easy to explain why trust plays a special role in banks compared to other sectors: When it comes to money, most people react highly sensitively. This money is usually held in a bank account. If there are rumors of a bank’s difficulties, be they justified or not, customers withdraw their funds as a precaution.

This is understandable, but also a fundamental problem. Because even the most solvent institution, equipped with proper equity capital, is more or less powerless and inevitably gets into trouble when it comes to a “bank run”. The fact that there is now an extremely comprehensive and sensitive set of instruments for measuring trust does not necessarily make things any better. The stock market is only the most conspicuous seismograph here.

There are also credit default swaps (CDS), those tradable papers that creditors can use to insure themselves against loan defaults. There is the interbank market, where you can see the interest rate conditions under which the financial institutions provide each other with liquidity; it is therefore a yardstick for the trust that banks have in one another.

When these indicators move into the red and the critical mass of those talking about them is large enough, the problems begin. It doesn’t help much when central bankers, chancellors or finance ministers assure the financial system’s solidity or even – as Olaf Scholz recently did – swear by the stability of a single institute, Deutsche Bank.

Despite a variety of measures: the regulators are failing

It is not uncommon for this to have the opposite effect of what was intended, because it arouses mistrust. In the worst case, it even reinforces the feeling that a similar disaster could happen again 15 years after the global financial crisis. Politicians, supervisors and central bankers have done a lot to make the banking system safer since the financial crisis. Deposit insurance has been expanded, capital requirements tightened and settlement mechanisms designed.

At the same time, banks need to hold more liquidity and undergo regular stress tests to determine how resilient they are to certain market scenarios. However, the emergency operations in the USA and Switzerland, where the state ultimately has to issue guarantees worth billions again, show once again that there is still a long way to go towards a system that meets regulatory and market-economy criteria and is at the same time secure.

>> Read also: Why the banking crises won’t stop

Measured against their own claims, the regulators have failed. There are several reasons for this. The basis of the banking business, the so-called maturity transformation, is a fragile construct: borrowing money in the short term, lending money in the long term – that makes people vulnerable to a loss of trust.

In addition, banks are not normal companies, they have an outstanding position as financiers of the economy and lenders to the state. Because of this, their business cannot simply be cut back to the point where they are harmless but no longer fulfill their function.

Trust comes with deposit insurance

They also have an ambivalent relationship with the state. Its supervisors regulate the banks, but at the same time it is dependent on them as buyers of its bonds. This then leads to the odd rule that banks don’t have to put down capital for government bonds because these papers are supposedly safe.

That financial history is also a history of state bankruptcies, including recent ones – so be it. Argentina and Greece have shown that holders of government bonds also have to cope with haircuts. Another problem: even with all government bonds, the turnaround in interest rates led to initially hidden losses on the balance sheets, which then have to be realized when the banks are forced to sell these papers for liquidity reasons – as was the case with the Silcon Valley Bank of the case was.

There are other entanglements: It is the state whose courts implement the claims of the banks against debtors, on which it mostly depends as a voter. It is the state that allocates losses in the event of bankruptcy – and not always according to clear principles.

In the case of Credit Suisse, for example, the Swiss regulators determined, contrary to conventional rules, that the creditors of subordinated bonds, i.e. the lenders, got nothing, while shareholders, i.e. equity providers, still got something. Bank regulation is therefore a highly complex and highly political business.

In the first phase of regulation after the bankruptcy of Lehman Brothers in 2008, the main focus was on tightening equity capital requirements as insurance against solvency problems. Now the three bank failures in the USA are putting the question of liquidity in the foreground.

However, a well-funded deposit insurance scheme is the main thing that helps against a bank run suffered by US institutions. Incidentally, such a plan was to be introduced across Europe on this side of the Atlantic, which failed due to German resistance. In retrospect, that might prove to be a mistake.

Because this also applies: Trust in good regulation is actually the beginning. Maybe not from everything – but at least from financial stability. And that’s not a little.

More: “Too big to fail”: The return of the banking problems scares politicians

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