The storm clouds of financial turmoil keep gathering. Daily the pocket pundits pen their notes, lamenting the parlous state of the banking sector, speculating on which bank will succumb to the pummelling of markets and nervousness of depositors after the Silicon Valley Bank (SVB) and Credit Suisse debacles.
But is the regulatory framework up to the job of reassuring markets? Might we face a media firestorm of self-fulfilling prophecies as headline risk fuels deposit runs and misery?
Certainly the twin headline-grabbers of SVB and Credit Suisse provide two fascinating but troubling examples of how carefully crafted and somewhat over-engineered bank resolution regimes can misfire.
There are now renewed calls for a regulatory overhaul against a background of shredded expectations for Swiss additional Tier 1 (AT1) bonds, or the contrasting balm of blanket depositor protection in the Californian sunshine. Some observers are even questioning the business models of banks in general.
What do these episodes tell us about the workability of the post-global financial crisis resolution framework for banks? What that crisis really did make clear was that a forced insolvency is immensely destructive. Fire sales of assets in falling markets completely destroy value and make fools of wise men.
Replacing conventional insolvency laws with a purpose-built, bespoke banking wind-up mechanism was broadly the right way to go, but any framework relies on trust and a measure of predictability. Time and technology have moved on since the resolution regimes were designed in 2015, and the recent failures have raised some troubling questions.
Read more on the recent banking turmoil
Now it seems even Swiss prosecutors are poring over the details of the Credit Suisse demise, although they are not questioning the legality of the trashing of the AT1 bonds (while leaving shareholders with some value).
Elsewhere, the call for greater respect for the natural order of creditors has become more insistent as the overall market threatens to treat the AT1 asset class as prohibitively expensive to issue or, at worst, uninvestable. Predictability will be key.
The second issue is the stickiness of deposits and liquidity ratios. Lines of panicking depositors were one defining image of 2007-08 in the UK. Regulators devised tougher liquidity ratios (the net stable funding ratio) for otherwise asset-sound and profitable banks, but in the light of recent events, many are asking if these rules really work.
In an age of apps and lightning-fast deposit shifts, a bank’s liquidity can be drained significantly faster than in the past.
The above questions are perhaps technicalities that require only tweaking or rebalancing. But there is a more fundamental issue that goes to the heart of the bank resolution regime mechanism.
Regulators like to have the element of surprise when dealing with a failing bank before it is completely flat on its back. They have therefore reserved for themselves the unilateral right to determine when the bank is about to fall over.
Regulators thus devised the concept of the ‘point of non-viability’ (or, as it has been termed, the ‘PONV’). This is the ultimate game of market chicken, a version of high-stakes, blind man’s buff.
The PONV is the juncture – undefined and surrounded by the mystery and majesty of regulatory power – where a bank is deemed to be so weak that it is unlikely to survive without intervention. Investors and other stakeholders, surprised by the recent failures, might well consider how this point is calculated.
In febrile, panicked markets, nervous investors will be trying to second-guess where the PONV might be set. Regulators, behind their Sphinx-like expressions, will endeavour to reassure, but provide as little as possible in the way of clues.
In calmer climes, the higher capital and liquidity ratios maintained by banks as a result of the revised regulatory measures post-crisis should give comfort. But as suggested by work done back in 2015-6 by a Icma-convened study group, there is the problem of investors incorrectly anticipating the PONV, thereby precipitating the regulatory intervention.
This potentially makes the system more unstable in tense times.
In the Credit Suisse saga, the whole recovery and resolution mechanism was road-tested for the first time for a big, systemic bank. In one sense the Swiss were successful, with many onlookers surprised by the timing and degree of the intervention.
Indeed, shareholders had only just put fresh money into the bank late in 2022. However, it is unclear to which warning lights the Swiss authorities had been paying most attention. Headline risk, sagging share price, ballooning credit default swaps, or something else?
Arguably, the reasons for the SVB or Credit Suisse failures were well flagged, and poor banking lies at the heart of their stories. However, the specifics of each of these cases have prompted a wider debate over the nature, direction and degree of regulation, and perhaps even the future role of banks.
On this the jury is still out, although pondering the PONV could perhaps become an investor sport for the brave-hearted. Let’s see what changes.
Tim Skeet has spent much of his 40-year career specialising in bank funding in the capital markets, including working on developments in these instruments from the earliest times. The views expressed here are his own.
