Banking is too risky to be left to bankers

With any luck – and we will need some – the maelstrom going through the banking sector and global financial markets will blow over without triggering the kind of meltdown we experienced in 2008. Yet, we have been reminded in the starkest possible way that while we made some, mostly larger, banks safer after the financial crisis, we did not make banking safe. Indeed, in some respects banking is simply too risky to be left to bankers, unless the regulatory environment is much tighter than it has become.

No doubt, the change from an era of cheap money and interest rates at close to zero to a new, “normalised” interest rate structure was always going to cause problems for some financial institutions. Yet, the scale of the problems in the US, and the speed with which they happened have taken most people by surprise, while the ramifications for the troubled European bank Credit Suisse have proved terminal.

The most urgent issue at the moment is indeed the collapse of Credit Suisse, one of Switzerland’s two banking giants. CS, to give it its short form, which had been doing business for 167 years, was what we call a GSIB, one of the world’s 30 global systemically important banks. The irony is that it survived the Lehman crisis better than its Swiss rival, UBS, but the latter has now bought the CS carcass and will keep what it deems appropriate (the wealth management activities and parts of the investment bank) and dispose of or consolidate the rest, or write it off.

CS, however, didn’t have the kind of exposure to chronically bad or overvalued assets that often trigger bank failures. On the face of it, it didn’t look like the kind of GSIB that was sending out traditional warnings of its imminent demise. Yet, away from the normal hunting ground of warnings, and its troubled acquisitions in the US, banking sector insiders knew CS was incubating trouble.

Even after the Lehman era, it suffered high turnover in its senior management, succumbed to serious fraud in its private banking business, had to manage open feuding between its CEO and another senior executive, was embarrassed by the Swiss banking regulator’s discovery of multiple cases of surveillance of executives, and ran into payments difficulties and losses with a couple of major clients as recently as 2021, including the disgraced financier Lex Greensill.

Given all this, it is hardly surprising that trust and goodwill, which are especially fickle and significant in banking, haemorrhaged out of CS before the deposits took flight. But it was also no surprise that the latter happened too in the wake of the deposit runs at Silicon Valley Bank, Signature Bank and Silvergate.

These three US banks also had their share of mismanagement, and were examples of smaller banks that were much less well regulated and scrutinised than their bigger peers.

Yet, it would be complacent to conclude that these incidents were all about weak managers and bad luck. These failures may not represent systemic risk in the same way as the collapses of 2007-2008, but we have learned that when deposit runs occur, these too can and do have systemic consequences, and it is for this reason that the Federal Reserve, Bank of England, Swiss National Bank, ECB and the Bank of Japan, and their political bosses have acted promptly to try to stop the rot. Whether they succeed or not should become clear in the coming days and weeks.

They will not be able to fix the fundamental problem so quickly that the last couple of weeks has again elevated, namely that privately owned banks want safe and liquid deposits with which they fund much riskier and volatile, and often illiquid loans and investments. Silicon Valley Bank, for example, took in billions of dollars of deposits from tech firms and proprietors which they used to buy long-maturity bonds which they did not manage or hedge appropriately. Many banks did this and it’s been estimated that the unrealised losses on this are over $620 billion in the US alone. Silicon Valley Bank had to realise those losses when its deposits vanished, and the authorities will be hoping that they have instilled confidence into depositors more broadly that their money is safe.

Yet this is the challenge that our politicians and regulators are up against. They need to resolve how to regulate all banks properly, not just the biggest ones. Also, once the dust has settled, they must convince depositors that their money is secure while ensuring they do not assume “moral hazard” in which all deposits are safe. Banks like SVB should be allowed to fail and losses shared among those affected.

Right now though there are two important issues in the crosshairs.

First, the Swiss authorities’ terms for the UBS takeover of CS include the wiping out of $17 billion of so-called “AT1” or additional Tier 1 bonds, issued to mostly institutional investors, hedge funds and so on. These are sometimes known as contingent convertible bonds (or coco’s) and are one of the riskier and more expensive ways in which banks fund themselves. Normally, it is equity holders who get wiped out first, but the Swiss have decided to do things a different way and other AT1 holders in other jurisdictions, holding over $250 billion worth of this asset class, may now be anxious about the precedent.

Angst may both cause volatility for banks looking to fund themselves, and push up still further the cost of capital for banks.

When the cost of capital rises for banks, especially if deposit stability is an issue, banks are most likely to curtail lending, and in extremis, shrink their balance sheets. If you hear economists talk about a shrinking credit multiplier, this is what they are talking about.

Second, if banks are facing uncertainty in their deposit flows, a higher cost of capital and greater regulation, then the likelihood of a shrinking credit impulse in the economy has to be considered high. The Federal Reserve, Bank of England and other central banks will be extremely mindful of this – or they should be – as they contemplate when and how to raise interest rates as part of the fight against inflation.

To a degree, tighter financial conditions triggered by the banking crisis will substitute for the tightening of interest rates by central banks, and so any previously anticipated rise at policy meetings this week in Washington DC and London, have to be reconsidered.

It seems unlikely that central banks are yet so spooked that they are going to shift towards a neutral monetary stance, and indeed that in itself may cause financial markets to worry. More likely is that they will continue to remind us that they are vigilant when it comes to lowering inflation, or that they have decided to moderate the rise in rates for a while, or pause pending additional feedback on the economic effects of the banking crisis.

What they should not do is carry on as though nothing has happened, because something of significance clearly has.

George Magnus is the author of Red Flags: Why Xi’s China is in Jeopardy, and had previously been Chief Economist at UBS, warning in 2006 –07 of impending financial turbulence