Bank Run

[윤영준]

Over the weekend, it was announced that UBS would take over its local rival, Credit Suisse, which suffered a series of scandals and financial losses in recent years. One of globally well-recognized banks with a long history of 167 years has now gone down as it required an emergency rescue against the continued outflow of depositors and investors. Apart from several unclear issues regarding the deal value, writing-off Additional Tier 1 (AT1) bonds and legal procedures related to the takeover, it may be the best way to end the further contagion in the financial system because UBS and Credit Suisse were both in a group of the 30 global systemically important banks. According to Swiss Finance Ministry, the bankruptcy of Credit Suisse would have had a huge collateral damage – on the Swiss financial market, risk of contagion for UBS and other banks, and also internationally. The deal, which was forced by the Swiss authorities and effectively nothing but a bailout, should provide time for UBS to restructure Credit Suisse as the latter was unable to convince the market of its long-term profitability even after the liquidity lifeline from the Swiss National Bank last week had not stopped the deposit flight.

This followed the collapse of Silicon Valley Bank and Signature Bank in the US last week. While concerns about Credit Suisse seem to be related to the viability of its business model, problems at the US banks have been one about interest rate risk and deposit flights. Now investors question which bank will be the next to go down (although it is clear that First Republic is on top of that list) and whether this could develop into another global financial crisis like 2008. However, the situation today is fundamentally different from the global financial crisis in 2008; banks are better capitalized and strictly regulated; private sectors are less leveraged now; housing markets are less extreme and the quality of mortgage debts is much improved. Nevertheless, the loss of confidence can still trigger a world-wide bank run, in particular, if people no longer trust our financial system and regulatory authorities.

Drastic interest rate hikes by central banks in the past 12 months caused a sharp fall in prices of interest-rate sensitive debt securities held by financial institutions. By the end of 2022, unrealized losses at US banks and financial institutions stood at $620bn according to the US Federal Deposit Insurance Corporation (FDIC). Although the US banking system as a whole does not have an extremely high uninsured deposit ratio or unrealized losses on held-to-maturity securities in excess of capital, unrealized losses and poorly managed interest rate risk could cause problems. For example, Silicon Valley Bank’s deposit base was drawn heavily from the tech sector with more than 95% of deposits uninsured and net unrealized losses approached more than 120% of its common equity Tier 1 (CET1). Challenging conditions in the tech sector led to a withdrawal of deposits, forcing SVB to sell securities. Once these assets were removed from SVB’s banking book to its trading book, it was forced to mark them to market, thereby realizing losses from long-maturity bonds caused by the aggressive rise in interest rates. These losses ultimately led to SVB becoming insolvent. Given the dominant positions in debt securities and loans owned by US commercial banks, they are greatly exposed to interest rate risk. Therefore, a loss of confidence and deposit flights in smaller banks can trigger another bank runs. Besides, potential risks also lurk in non-bank financial intermediaries and shadow banking sectors as financing costs soar and loan default rates rise due to tightening lending conditions.

Whereas non-financial companies are straightforward income statement businesses from an accounting point of view, banks are balance sheet businesses. Therefore, assessing the banks requires careful analysis of balance sheet assets and liabilities. Banks carry two types of risk. The first originates from problems on the liability side of its balance sheet. These usually come in the form of deposit flight or a loss in counter-party confidence that prevents the rollover of wholesale funding. The immediate consequence is a liquidity crisis. The second stems from problems on the asset side of the bank’s balance sheet: either a rise in loan default rates or a collapse in security prices, both of which erode the value of its assets. This can lead to a solvency crisis. The two are often inter-linked, with liquidity problems leading to solvency problems (in case of SVB) or solvency concerns leading to liquidity issues (classic bank run). After 2008, the major economies introduced the tough rules on bank capital, liquidity and resolution. Therefore, supervisory lapses partially contributed to the recent bank failures even if they largely reflected mismanagement at each of the three banks. Moreover, after missing opportunities to arrest inflation at early stages, central banks had to embark a draconian tightening cycle, which caught many institutes offside.

Because the banking system in developed markets as a whole is better capitalized to withstand losses on the asset side of their balance sheet, the contagion of bank run may come from development on the liability side of banks’ balance sheets. History shows that policy responses matter during the financial crisis. Now governments are ready to backstop to shore up confidence among depositors, and central banks also have various tools to provide liquidity to financial institutions. This includes new lending facilities, extensive currency swap lines between central banks as well as the Fed’s own standing repo facility and the ECB’s LTROs and TLTROs. As the Bank of England demonstrated during the mini budget crisis in October last year, central banks can pump substantial liquidity to markets while raising interest rates in order to quell inflation as long as the current crisis does not escalate into worst case scenarios.

What are the implications of the recent bank failures for the future monetary policy? It is clear that a banking sector in difficulties will more or less by definition tighten financial conditions. As a result, bank lending will contract, which in turn would weigh on consumer demand and business investments. As the real economy decelerates, a rise in credit defaults feeds back to a further tightening of credit conditions, creating a deeper recession in the real economy. A brutal drop in short-term interest rates appears to argue that terminal interest rates will be lower than the market had anticipated at the beginning of March. This highlights the risks posed by the dominance of the financial sector. As ever, monetary policy of central banks becomes a fine balancing act to achieve simultaneously reducing inflation, maintaining financial stability and minimizing the damage to growth and jobs.

[좋은세상]

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