The myriad risks of banking instability

The banking system is driven by confidence and when that confidence evaporates, the risk of contagion becomes real and dangerous, writes Jim Power

One of the abiding memories of the great financial crisis back in 2008 and thereafter was the virtual collapse of the global financial system following the implosion of the US sub-prime mortgage market. 

This implosion created a domino effect around the world and its tentacles spread far and wide, devastating the Irish banking system. 

The Irish banking system was ripe for devastation after nearly a decade of excessive lending and poor lending standards. 

A banking system is driven by confidence, but when that confidence evaporates, the risk of contagion becomes very real and very dangerous. This has played out in recent weeks. 

Silicon Valley Bank collapse

In the second week of March, Silicon Valley Bank (SVB) became the second largest bank in US history to collapse and the biggest lender to fail since the 2008 crisis after customers rushed to withdraw cash due to fears over its liquidity. 

SVB was a bank that loaned money to start-up companies mainly in the technology area and it also provided other financial services to both start-ups and other technology companies. 

Another US bank, Signature Bank, was also shut down by the Federal Deposit Insurance Corporation (FDIC). The earlier collapse of crypto-bank Silvergate did not help matters. 

The FDIC forced SVB bank to cease operations on 10 March. At the peak of the technology boom, SVB placed $91 billion of its $188 billion in deposits in long-dated securities such as mortgage bonds and Treasury securities. 

The value of those bonds had fallen heavily over the past year, however, as the Federal Reserve increased short-term interest rates aggressively. 

The value of its assets was also adversely affected by the sharp correction in the global technology sector over the past year. 

The bank sought to raise funding of $2.25 billion to cover the losses on its bond portfolio, but without success. This contributed to a run on its deposits and the closure and eventual sale of the bank by the FDIC. 

In an FDIC insured bank, up to $250,000 is guaranteed, but the problem for SVB, reflecting the nature of its client base (it had almost 40,000 customers), is that an estimated 93 percent of deposits were not covered as they are over the threshold. 

For a normal bank, it is estimated that around 50 per cent of deposits are guaranteed. 
This lack of insurance created serious concerns amongst depositors, and we basically witnessed an old-fashioned run on a bank. 

Although slightly different, Signature Bank had similar difficulties. In response to the crisis and the risk of contagion, the US authorities responded quickly and aggressively. 
First, Treasury Secretary Janet Yellen instructed the FDIC to make whole all depositors with both SVB and Signature Bank out of its Deposit Insurance Fund. 

The aim was to shore up confidence among depositors at US banks. Concerns about moral hazard are being ignored for the moment.

Second, the Federal Reserve introduced a new lending facility to provide additional funding to banks that run into liquidity problems. 

The new Bank Term Lending Program (BTLP) will operate alongside the Federal Reserve’s existing repo facility and will provide loans at a duration of 12 months. 
Crucially, the qualifying assets for access to these loans will be valued at par (rather than marked to market). 

This should ensure access for institutions sitting on unrealised losses in their held-to-maturity security portfolios.

Developments in Europe

Recent banking problems have not been confined to the US. In Europe, CSFB has had to be acquired by its larger competitor, UBS. 

In the case of CSFB, the vultures have been circling for some time due to a series of scandals in recent years.

These have included the largest trading loss in its 167-year history after the implosion of Archegos Capital, and the closure of $10 billion of investment funds linked to a collapsed financial firm, Greensill. 

It was revealed that the bank’s auditor, PwC, had identified material weaknesses in its financial reporting controls, which delayed the publication of its annual report. 

It is possible to go through each of the troubled banks in turn and conclude that the problems are somewhat unique and are not reflective of the global banking system in general, but the list is getting longer.

The heavy concentration of bonds on the SVB balance sheet created the main vulnerability for that institution, but there is once again a more general concern about bank regulation, and particularly the deregulation engineered by Trump in 2018 in response to intense lobbying and a somewhat warped ideological belief system. 

His reforms basically reduced the regulatory supervision of smaller banks and indeed the CEO of SVB lobbied heavily for such a relaxation of supervisory standards in the past. The reality is that all banks need to be heavily regulated. 

Central banks will continue to respond aggressively to seek to contain any banking problems that might arise in the months ahead. 

The likelihood is that further problems will emerge given the move away from the intoxicating effects of artificially low interest rates. A decade of Quantitative Easing was always going to give rise to challenges. 

The recent problems for Deutsche Bank clearly illustrate just how nervous the markets are at the moment and how an apparently relatively stable bank can get into difficulty. 

Irish banking system

For the Irish banking system, the main risks are more likely to be caused by global contagion rather than any inherent balance sheet problems. 

In fact, the balance sheets of the Irish banks look relatively solid due to quite stringent capital requirements and other regulatory requirements introduced over the past decade. 

We should be thankful for this, but also recognise that the radically changed monetary policy environment has the potential to cause difficulties in areas that might not appear obvious. 

The current banking difficulties are likely to increase the cost of funding for banks, pressurise profitability, lead to tighter lending standards, reduced credit availability, and result in more expensive banking services. 

Given the fundamentally important role played by banking from an overall economic perspective, such outcomes would undermine activity and damage growth prospects. 

Perhaps, it will now take some momentum out of central bank interest rate tightening. 

It is not 2008, but it still feels uncomfortable. Banking volatility can now be added to the long list of global economic risks we are facing.