Market Economy

Better Safe than Sorry

Questions are again swirling about how brittle banks are, and whether regulators have been caught out. There is a need to build a regime that recognizes the risks from interest rates hike.

By Sara Danial | July 2023

Time indeed flies. I remember studying Economics and Management during my student life, and today it only seems like yesterday when our professors explained the capitalistic nature of the market economy. Fast forward to my professional life, I witness the breaking down of American Capitalism right before my eyes. After the nightmarish 2008-2009 global financial crisis, one would’ve thought that we had learned our lesson. Clearly, banks still possess the unending power to leave us with a heart-stopping scare.

One wonders if it were Trump-induced regulations, banks’ risk mismanagement, interest rate hike – or a well-aligned combination of all three.

To devise a rescue, the US government made an intervention to prevent a major banking and financial crisis yet again, owing to which the midsized lending saviour of the tech start-ups, Silicon Valley Bank, crashed, sending shockwaves through the entire financial system. The bank was troubled when the interest rates increased, the treasury yields tumbled, and the value of its bond-holdings plunged. Under the crunch, the nervy depositors pulled out their money. In a failed effort to plug a shortfall in finances, the share price dropped. In March, HSBC purchased SVB’s British assets for £1, but America’s regulators have struggled to find a buyer for the rest of the bank.

Fourteen years since the global financial crisis took place. It doesn’t take an economic scientist to realize that the experience should have made us wiser. Yet, here we are again, with frantic regulators and frightened investors. Questions are again swirling about how brittle banks are, and whether regulators have been caught out. The fiasco clearly reflects how the banking sector stands as a major ward of the state. Nothing short of an accounting fiction, I’d say.

If that wasn’t enough, the embattled lender Credit Suisse announced it intends to borrow up to SFr50bn from Switzerland’s central bank to bolster its liquidity and buy back SFr3bn of its distressed debt. In the market meltdown with a febrile atmosphere, the bank’s largest investor, Saudi National Bank, decided not to increase its stake in the business.

Coincidence? Hardly. To state the obvious, both crises are clearly linked. Only revealing long overdue hidden stress.

The high-speed collapse and the size of the failures disrupted the markets, wiping billions off banking stocks. The collapse continues to reverberate, bloating the political blame game.

In a coordinated feat, the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation intervened to protect depositors. They set up a facility that allows banks to tap emergency funds.
The Fed may be right in proving the necessary rescue against good collateral to stop runs. But, easy terms carry a cost. Creating an expectation that the Fed will assume interest rate risks in a crisis only enables and encourages the banks to behave recklessly.

Not only does it complicate the Fed’s road to further monetary tightening, but it also has to weigh up stability in the financial system and inflationary pressures. While the annual inflation reduced to 6%, the core annual rate (stripping out the food and energy prices, which economic scientists fret about) remained nearly unaffected at 5.5%. The labour market is a mess in and of itself.

It is important to focus on fixing the system. Because while the emergency programme will be a helping hand for a year, it won’t be long before banks begin to take excessive risks in pursuit of high returns. The system must be safer.

One actionable deliverable can be to remove various odd exemptions that apply to mid-sized banks, many of which were the result of post—crisis rules being rolled back amid much lobbying in 2018 and 2019.

The rescue action plan of SVB drives the point home that the policymakers think such banks pose systemic risks. If so, they should face the same accounting and liquidity rules as the megabanks — as they do in Europe — and be required to submit plans for their orderly resolution in case of failure. Effectively, this will force them to increase their safety buffers.

Industry experts and policymakers should build a regime that recognizes the risks from interest rates hike. It is a small wonder that a bank with unrealized losses is more vulnerable to failure during a crisis than one without them. My question remains, why is this disparity not reflected in capital requirements?

Perhaps a stress test - what will happen to the bank’s safety cushion if its bond portfolios are marked to market, and if rates kept increasing? It is then for the policymakers to decide whether the system has sufficient capital.

Bankers, of course, won’t be the most amused about this. They will loathe the idea of more capital buffers and rulemaking. But it is better to be safe than sorry. The gains from safety are massive. Depositors and taxpayers ranging from Silicon Valley to Switzerland are rattled with a mighty scare. They do not deserve to live with constant anxiety and fright they thought had been historically put to rest.