Early Lessons from the Recent Banking Turmoil

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Publication: F&D Magazine; Analytical Series; May 9, 2023.
Author/interview: Marjorie Henriquez interviews Lucrezia Reichlin, professor of economics at the London Business School.
Triggering events: collapse of Silicon Valley Bank on March 10; subsequent strains in other US regional lenders; failure of Credit Suisse about a week later; failure of the US’s First Republic more recently.
Core argument: protecting taxpayers’ money remains the ultimate goal when dealing with banking crises.

Commonalities identified:
- Regulatory failures and poor risk management.
- Both US and Swiss episodes were triggered by the increase in interest rates related to the synchronized and harshest monetary policy tightness since World War II.
Distinctions between episodes:
- US cases (e.g., Silicon Valley Bank): midsize banks with assets dominated by safe government bonds whose mark-to-market value declined as interest rates increased; deposits concentrated in particular sectors.
- Credit Suisse: a very large institution with long-standing idiosyncratic problems more broadly defined.

Liquidity interventions:
- Central banks are considered well equipped to face generalized liquidity crises through timely provision of liquidity.
Insolvency resolution:
- Tools exist in principle to deal with single-institution insolvency (bail-in or bailout), but such crises are rarely managed in an orderly way.
- Trade-offs: a bail-in may cause financial instability; a bailout causes moral hazard and is an implicit subsidy.
National resolution practice:
- Common response has been a national regulator facilitating a merger with a national bank via moral suasion, subsidy, or both (example: UBS absorbing Credit Suisse at unfavorable exchange for Credit Suisse shareholders).
- Limits of this approach when only one national bank remains or when cross-border mergers involve differing national interests.

Resolution framework concerns:
- Banking Recovery and Resolution Directive prevents any bailout before 8 percent of the unweighted balance sheet of a troubled bank has been bailed in.
- Many smaller and midsize banks cannot satisfy the 8 percent bail-in rule without hitting depositors because they do not hold enough debt that can be bailed in.
- Under these circumstances, the US approach to Silicon Valley Bank would be illegal in the EU.
Deposit insurance and systemic protection:
- Deposit insurance in the EU is 100,000 euros.
- There is no systemic risk exemption in the EU comparable to the US practice of protecting depositors in cases where a bank’s collapse would pose a risk to the entire financial system.
- The banking union does not involve common deposit insurance at the EU level, creating fragility and market segmentation through depositor flows toward countries safer on public finance grounds and banks’ home-sovereign bond holdings.

Policy tools and interactions:
- The short-term interest rate is the principal instrument in a tightening cycle; liquidity injection can address financial stability problems without necessarily jeopardizing price stability.
- Examples cited include the effective handling of the Silicon Valley Bank crisis by the US Fed.
Tightening consequences:
- Squeezing credit is part of monetary tightening and can cause bankruptcies (reference: Paul Volcker’s remark to Alan Blinder: “by causing bankruptcies”).
- Some parts of the system will run into solvency issues as a consequence of monetary policy tightening; historical precedents include Continental Illinois and the savings and loan bank crises after Volcker’s tightening in the early 1980s.
Regulatory capacity:
- Regulators are often behind the curve; if a deep recession occurs, many institutions could face solvency problems that will test crisis-management frameworks.
- Fiscal authorities and institutions like the Federal Deposit Insurance Corporation will have roles in dealing with crises and their taxpayer costs.

Two general lessons from the Silicon Valley Bank episode:
- Not only big banks but also midsize banks can create contagion; the systemic vs. nonsystemic distinction is of limited utility because all crises can have potentially systemic effects.
- All deposits are potentially volatile; partial deposit insurance is not credible.
- In the Silicon Valley Bank case, all depositors were bailed out, effectively gifting wealthy depositors.
- One solution: insure all deposits ex ante (acknowledged as expensive).
- A radical alternative: reforming the system toward central bank digital currency or narrow banking, with financial institutions limiting activity to low-risk short-term investments — noting that such changes would have significant consequences for the banking industry and must be carefully considered.
Lessons from Credit Suisse:
- Too early to draw definitive lessons; Swiss solution may have prevented financial instability but likely involved government compensation to UBS for potential losses and may not be costless for taxpayers.
- Creation of a “monster bank” larger than the Swiss state underscores that a bank’s death is messy and costly and prompts reflection on banks’ business models and safer alternatives.

Silicon Valley Bank collapse: March 10 (year implied in narrative).
Banking Recovery and Resolution Directive: 8 percent bail-in requirement.
EU deposit insurance level: 100,000 euros.
First Republic acquisition:
- Acquired by JPMorgan.
- JPMorgan obtained a $50 billion, 5-year fixed rate loan from the Federal Deposit Insurance Corporation; the interest rate has not been disclosed.
- Concern that the deal terms appear very favorable for JPMorgan and that more midsize banks remain under threat while stocks of large banks are failing.

Source: Early Lessons from the Recent Banking Turmoil, F&D Magazine, May 9, 2023; interview with Lucrezia Reichlin.