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RegulationsJune 2 2023

Bank runs in the digital age

Bank runs will always happen, but there are ways lenders can limit the damage, writes Etay Katz.
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Bank runs in the digital ageImage: Getty Images

The collapse of Silicon Valley Bank and the recent liquidity difficulties faced by other banking institutions has brought to the fore a number of fundamental questions about the nature of banks’ business models, the role they play in a modern ‘digital’ society and perhaps most importantly, whether anything meaningful can be done to alleviate the risks of a run in the digital age.

To quickly recap, most banks (with the exception of some niche institutions seeking to operate as a bank for other reasons such as access to payment system) operate a version of ‘maturity transformation’: that is, they borrow monies with short repayment periods, mostly from depositors, and lend it for longer periods. 

The degree of stability (‘stickiness’) associated with banks’ deposit base is a function of a number of fundamental factors including the degree of flexibility or term for which the deposit is held, and the type of customer and account, for example business/retail and saving/current.

To these factors one must add the creditworthiness of the bank concerned, normally evidenced by credit rating (for banks with publicly issued debt securities) and equally, if not more importantly, the scope of protection that depositors receive from the relevant deposit insurance scheme on failure.

Deposit insurance schemes evolved over the years to provide protection for certain types of depositors up to a defined limit, and generally have had the effect of increasing depositors’ trust in banking institutions.

Read more on The Banking Saga 

Deposit runs are universally caused by a chain of events that in aggregate result in depositors no longer having a high degree of trust that the bank is stable and can return their deposit monies when asked to do so.

While this may occur much earlier and faster among depositors that are not protected by a deposit insurance cover, it must not be assumed that insured depositors would not participate in a run should one occur.

Commercial and financial information about the health of banking institutions is no exception to other data existing in our modern society. There is an inordinate amount of it circulating in publicly available media channels.

On many occasions factually true information is conflated with false or imaginative/fictitious information which can combine to lethal outcomes in terms of reactive behaviour by digitally enabled customers.

Banks have liquidity plans which include elements of scenario planning, stress-testing and mitigation measures that are designed to respond proportionately to those such that the bank remains able to meet its liabilities when called upon.

However, no bank is immune to an ‘outlier’ adverse scenario which can wreak havoc for its liquidity position and also capital position caused by losses on a firesale of assets. In some scenarios, not even central bank liquidity windows can save the day.

Protecting trust

There are various factors that conspire to potentially erode faith in banks under adverse news pressures.

First, banks that are experiencing a spiral situation where losses are ramping up, requiring drastic balance sheet management and potential recovery actions, may need to publish such data under securities laws. This is where the bank has either its equity or debt securities trading in the public markets.

Such disclosure will in most situations act as catalyst for bank stakeholders to lose trust in the creditworthiness of the bank. Unfortunately, such effect will accelerate a downfall that may or may not be inevitable.

Recent examples of this have exposed different banking business models operating in different niche areas of the market. This is a demonstration that no particular bank asset/liability model is immune.

the notion of a bank being ‘systemic’ is in reality much broader than has been defined in regulatory or statutory standards

Inevitably, scale is a mitigating factor, and deposit diversification is yet another potent mitigant. Another lesson of recent events is that the notion of a bank being ‘systemic’ is in reality much broader than has been defined in regulatory or statutory standards.

We have witnessed extraordinary interventions by authorities, particularly in the US, involving private sector banks to prevent the demise of smaller banks which in theory could have been allowed to fail and for depositors to fall back on deposit insurance for reimbursement. 

However, recent events prove that regulators and politicians have become very sensitive to even the smallest banks falling into financial distress. This runs counter to principles of prudential regulation (accountability for normal moral hazard risk existing in free markets), and raises the question of whether banking is essentially a public utility which must be regulated so highly such that the deposits of a bank can never fail to be returned.

This will of course mark a major departure from historical banking regulatory axioms and make banking a more costly and less competitive service.

The role of law enforcement

There is no obvious solution to stopping disinformation in the market about the financial health of banks in a way that will stave off the possibility of a bank run. We are all susceptible to the ‘herd effect’, whether it is based on true or false data.

One aspect that is within the control of banks is to take a pre-emptive media approach during a period of build-up of losses or financial stress. This requires thoughtful and well-rehearsed procedures and staff able to provide first aid responses to false rumours.

The role of regulators and law enforcement authorities is equally vital, the former in quelling untrue rumours publicly and reassuring depositors of measures in place to ensure a sustainable future for the bank concerned. Law enforcement authorities must bring to justice people who maliciously spread rumours or seek to cause a panic with respect to banks.

Where banks have publicly listed securities, this can be effected through an accusation of market manipulation, a criminal offence in most advanced economies. 

Banks must factor communications, true and false, into their scenario planning and liquidity modelling

The reality, however, is that controlling social media platforms, investors’ chatrooms and so on is at best difficult. By the time the disinformation is sufficiently widespread to reach law enforcement, it may be too late to take preventative action.

The immediate action taken by authorities in response to the recent crisis was to seek to expand the range of insured depositors and possibly the quantum of protection. Some of these actions are to be welcomed, for example with respect to money held by intermediaries that effectively belongs to their customers.

However, the expansion of deposit insurance beyond that in either customer type or quantum or both raises concerns about turning deposit-taking into a public utility, with significant structural consequences to free market principles and moral hazard/accountability by bank office holders.

Banks must factor communications, true and false, into their scenario planning and liquidity modelling. Failing to do so is to risk many more cases of collapse and/or absorption by larger institutions, thereby diminishing competition and further eroding public confidence in banks as trusted institutions. 

 

Etay Katz is a partner at law firm Ashurst. 

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