Post-global financial crisis reforms have helped…
The report first importantly notes that many post-global financial crisis (GFC) reforms have helped. Stresses would have been worse and recovery more extended had capital and liquidity buffers been less strong. Also, many authorities acquired intervention tools that proved crucial to defuse systemic risk. In the EU, the reform fruits included the Single Supervisory Mechanism (SSM), which helped strengthen prudential buffers, clean up balance sheets, and build more effective supervision, allowing its banks to navigate the turmoil virtually unscathed. In Switzerland, the sector overall proved resilient and could support authorities in managing the failure of Credit Suisse.
… but are still incomplete
Yet, events also showed that reforms remain incomplete, with the need for large interventions to stabilise banking systems further proof of this. In the US and Europe, Basel III is still to be finalised and fully implemented. And many question the credibility of the recovery and resolution regimes for G-SIBs, and whether bailouts and other official supported solutions remain necessary sins.
Monetary policy in the US and Europe contributed to the financial instability
Events also showed reform gaps, old lessons forgotten, and evolving risks. The US bank failures are often largely attributed to their poor risk management and weak regulatory oversight. But the central bank’s expansionary policies, in the form of low interest rates and quantitative easing, mostly in place post-GFC and further boosted during the pandemic (Figure 1), led to a liquidity dependence at banks. Besides the failed banks, many other US mid-sized and regional banks saw their (uninsured) demand deposits grow fast and maturity mismatches balloon. Absent rules for interest rate risk, a major gap, and given weaknesses in supervision, this vulnerability went largely uncorrected. In early 2023, following the interest rate hikes, investors caught on and the riskiest banks encountered liquidity withdrawals. The digitalisation in finance and the quick spread of information compounded the runs. Solvency problems arose in part as (official) liquidity support – notably from the lender-of-last-resort (LoLR) − was not sufficient and available fast enough. As many other banks experienced simultaneously large withdrawals of deposits and faced runs, a possible systemic event resulted. In Europe, many banks also saw their demand deposits grow fast and the Credit Suisse case also showed as deficiencies in LoLR mechanisms. And events showed weaknesses in the coverage and design of deposit insurance schemes
Figure 1 Monetary aggregates grew very fast relative to banks’ in the US, less so in the euro area
Note: Yearly flows as a percentage of bank liabilities.
Source: FRED and ECB
Funding fragility is a key source of run risk in the US requiring substantially more capital
For the US, funding fragilities remain the main vulnerability. Many banks still have considerable interest rate mismatches combined with large valuation losses, and additionally for some, significant commercial real estate exposures (e.g. Doolittle et al 2024). This means a clear tail of weak banks (Figure 2). As in March 2023, this can trigger solvency runs that do not resolve based on temporary liquidity injections. Furthermore, official sector responses to the risky funding structures and the very speedy liquidity withdrawals appear limited so far. The risks of runs and broader contagion thus remain high.
Figure 2 With monetary policy tightening, many US banks are potentially underwater and insolvent
Notes: CRE = commercial real estate. Histograms of equity-to-asset ratios, valuing all non-equity liabilities at face value, under three scenarios: 1. 2022Q1 as reported. 2. with valuation losses from rate increases. 3. with 10% default and a 70% recovery rate on CRE loans.
Source: Jiang et al. (2023c).
To ensure stability, the report suggests a ‘market test’ by requiring banks with capital shortfalls to promptly raise new equity. Between $190 to $400 billion in equity would effectively reduce the risk of runs. If banks cannot raise capital right away, regulators would do a stress test to clarify which banks need equity on a marked-to-market basis. Rules for interest rate risks and a related Pillar 2 capital charge would further improve incentives to ensure that banks remain going concerns in any future scenario.
High risk, low profitability, and inefficiencies depress the market values of European banks
In Europe, bank capitalisation and liquidity had much increased prior to the events, thanks in large part to improved regulation, centralised supervision (SSM) and greater centralised oversight of national supervisory agencies. But significant vulnerabilities remain and even with recent improvements in profitability, bank valuations are low. This suggests besides some risks, limited franchises – reflecting current market structures and threat from competitors − and less-than-efficient operations. Furthermore, significant swaths of banks, being public sector owned and/or weakly governed, do not face full market discipline. Importantly, the Banking Union remains incomplete as deposit insurance remains nation-based and the crisis management toolkit is still ineffective.
These deficiencies help explain why European banking has not seen major structural change over the last decade. It is still largely nation-based, making for a system that shares risks poorly, is less competitive, and does not serve consumers and firms well. The recent higher bank profitability provides a window to move to more viable business models and market structures. This demands a step up in cross-border M&As, notably within the euro area. Facilitating this requires, additionally to a complete Banking Union, a new EU-wide bank charter with no intra-euro limits on the movement of capital and liquidity for banks having the structure, organisation, and ambition to engage in cross-border banking and committed to support all their entities in case of stress.
Institutional changes are needed to ensure financial stability
To ensure financial stability globally, a better integration of monetary policy and financial stability is needed. Events revealed again that monetary policy matters for financial stability, with vulnerabilities emerging and triggering stress on banks’ liability side this time. Recommended steps include improving the analyses, staffing, and processes at central banks and supervisory agencies, conducting more systematic assessments of the stability implications of both conventional and unconventional monetary policies, using a wider set of interest rate scenarios in stress tests, and adjusting the pace of quantitative tightening in light of its effects on financial stability.
Additionally, supervision remains too fragmented. In the US, chartering banks can forum shop for more lenient agencies (federal, state), making for major differences in the quality of oversight, which, in combination with weaker rules for smaller banks, contributed to the failures. The report recommends rationalising the various agencies to enhance their effectiveness. In Europe, the system, with its mix of national members and supranational agencies and often the need for majority decision-making, remains unwieldly. Furthermore, like in the US, supervision has been too compliance oriented.
Globally, deficiencies in the frameworks for managing recovery and resolution remain large, especially for G-SIBs, as the first test case showed. While Credit Suisse failed without much contagion, the solution Swiss authorities deployed shows the need for reforms to the ‘too big to fail’ framework globally. In cases of going concern weaknesses, the report calls for a workable recovery regime that triggers supervisory actions early − thus avoiding acting ‘too little, too late’ – provides supervisors with sufficient powers and instruments to make a weak bank sound in a short time, and mitigates the risk of runs and their consequences if they do occur. To enhance resolution in gone concern cases, it calls for more and earlier use of contingent debt conversion, greater ease in moving liquidity and capital intra-groups upstream and across borders, sufficient public liquidity backstops, and more options and alternatives to open bank bail-ins. Furthermore, the report suggests improving the markets for contingent equity claims, using Additional Tier 1 bonds as going concern recapitalisation instruments, and reducing legal uncertainties about bail-in bond conversion. While appearing highly technical, these design features are crucial for recovery and resolution of GSIBs to operate smoothly across borders and to make the promise of ‘no bank too big to fail’ a reality. Ultimately, though, for many banks − whether systemic or not − higher capitalisation in the form of plain vanilla equity will likely be the most simple and effective solution to ensure stability and also the one most robust to the inevitable regulatory arbitrage and political pressures.
The report ends on a cautionary note by describing what might occur if policymakers do not act sufficiently. It points out the risks of renewed bank runs in the US, and it notes the possibility of more zombie banks and firms in the US and Europe.
References
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