SOLUTIONS TO THE EU BANKING TURBULENCE

Healthy banks are essential to safeguard financial stability. The recent collapse of three US banks and one in Switzerland has shocked global financial markets, and the tremors continue to this day. The speed with which these entities withdrew and the strength of the market reaction cast doubt on the ability of current frameworks to contain the consequences of such events.

Although not all bank failures can be completely avoided, European banks and supervisors have taken great steps to reduce risks and strengthen the resilience of the system to shocks. Completing the banking union and the capital markets union will help prevent crises, by improving risk sharing, and contain their aftershocks, thanks to a stronger safety net.??The full implementation of the Basel III reform will also strengthen the existing EU regulatory framework, which has proven critical in bolstering the financial sector during the pandemic, as well as limiting the contagion of turmoil in the US.

THE FASTEST MONETARY ADJUSTMENT CYCLE IN RECENT HISTORY

We are experiencing the fastest tightening in recent monetary history. In the span of just over a year, the Federal Reserve raised interest rates by 500 basis points, the Bank of England by 400, and the European Central Bank by 375.

1). Understandably, after more than a decade of ultra-low rates, financial institutions are struggling to adapt to rapid changes: financial conditions continue to tighten due to persistent inflation expectations and rising real interest rates.

THE FASTEST RISE IN INTEREST RATES SINCE THE BIRTH OF THE EURO

With strong capital buffers, a balanced liquidity position and very low impaired assets, euro area banks look strong, even when looking at the weakest banks

Higher policy rates have also eased some price pressures on banks, allowing them to increase net interest margins and expand their capital through retaining earnings.

"Euro area banks have increased their capital positions since the global financial crisis."

NOTE: Total Capital Index, distribution across countries over time

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ALSO MAINTAIN SAMPLE LIQUIDITY RESERVES?

NOTE: It was one of the highest capitalization of reserves in the last 20 years, according to the Liquidity Coverage Ratio (LCR) by country in the euro area, at the end of 2022 it was very solvency.

"Non-performing loans remain very low, even compared to historical standards."

NOTE: Impaired loans/gross loans, distribution across euro area countries over time

PRESENT

Still, high interest rates and rapid changes can expose vulnerabilities in banks' asset and liability management. And tight financial conditions in the euro area will continue to stifle credit demand and cloud the risk outlook, hampering banks' operations.?

In such circumstances, it would be naive to exclude new challenges for the banking sector.

SOME BUSINESS MODELS CRUMBLE BEFORE RISES IN RATE

Postmortem investigations into the recent financial turmoil affecting the US and Switzerland, including the self-criticism of the Federal Reserve Board, offer insights for Europe.

[1]?"All three US banks collapsed due to an over-reliance on cheap funding from large uninsured deposits combined with investment strategies vulnerable to sharp interest rate rises. Poor governance and reduced supervision failed to detect nor did they scale back doomed trading strategies in a tightening cycle, which exacerbated the situation. As soon as investors and depositors suspected something was wrong, they quickly withdrew their trust and their money."

SCENERY

Credit Suisse's fate played out somewhat differently, but a similar problem of an overly lenient risk management culture, compounded by prolonged poor profitability, ultimately undermined confidence in the bank and led to its demise.

In the end, market discipline worked by weeding out unfit entities. The process has arguably been more costly than necessary, as large shortcomings cannot be left to the penalizing behavior of market participants.??Regulation, risk governance and supervision should do their part first.

Although the turmoil in the US and Switzerland has not spilled over to euro area banks, complacency would be unwise and could lead to ignoring important warnings for Europe.

WHAT ARE THE LESSONS?

Lesson 1:?CONFIDENCE MATTERS MORE THAN SIZE

The turmoil in the United States involved entities that are not among the largest in the country. However, its size was enough to raise concerns about the viability of other banks and the safety of deposits elsewhere.

[2]?"Restoring confidence required strong statements of support and bold actions. The line between too-big-to-fail institutions and non-systemically important institutions may not make sense during a crisis when depositors' money is at stake ".

[3]?"Furthermore, resorting to bailout solutions and overriding rules in a crisis can undermine public confidence in the existing safety net and decrease incentives for banks to hedge against risk, potentially creating moral hazard."

Lesson 2:?SPEED IS ESSENTIAL

Bank runs occurred at unprecedented speed. By way of comparison, the demise of Washington Mutual, the largest bank failure in US history, came after a nine-day outflow of 9% of deposits (or $16.7 billion).

Silicon Valley Bank, for its part, was contemplating a loss of 80% of its deposits in less than two days (USD 142 billion of USD 175 billion).

Bank runs in the digital age could happen in a matter of hours; governors will need to accommodate this speed.

Lesson 3:?FOLLOWING THE RULES PAYS OFF

In its review of Silicon Valley Bank supervision and regulation, the Federal Reserve Board admits that the partial rollback of the 2019 regulations prevented stricter supervision of the bank.

Consequently, the adaptation of the rules resulted in the bank being subject to?“lower regulatory and supervisory requirements”.

[4]?"Stronger rules (similar to Basel III) help identify risks earlier."

Lesson 4:?CLOSE COORDINATION IS NECESSARY

The rapid resolution of all the entities has had the close collaboration of three actors:

1Deposit insurance agencies that fulfilled their fundamental mission of restoring confidence by reiterating, and even expanding, their commitment to deposit safety. Central banks that coordinated vital liquidity support, either through direct liquidity injections or by orchestrating the support of other lenders.

2Governments also stepped in to back national champions, such as other large banks in the same jurisdiction, which eventually stepped in and acquired the failed entities.

SYNTHESIS:

All actors came from the same jurisdiction and were able to rapidly create partly new and immediate solutions and mobilize resources to stabilize the crisis.?

In Europe, action across different levels of government and countries is by nature more complex and rule-bound, requiring an even higher level of preparation and foresight.

RIGHT ACTIONS

These lessons underscore the importance of pursuing the completion of the banking union with renewed energy. A complete European banking union would greatly improve the system's ability to absorb shocks and contain the spread of risk.

To carry out this effort, we consider the following actions a priority:

Action 1:?IMPROVE DEPOSITS INSURANCE AND RESOLUTION FINANCING THROUGHOUT THE EURO AREA.

Although member states already have functional national deposit insurance schemes, more homogeneous rules and practices would provide greater legal certainty to depositors and market participants.

The implementation of the new legislative proposal for crisis management and deposit insurance presented by the European Commission would guarantee a more harmonized and credible framework in all member states.

[5]?"Robust support mechanisms, based on bank contributions, are also essential to avoid resorting to public money to deal with banking crises. Once in place, the common ESM support for the Single Fund Resolution will contribute to this objective".

Action 2:?TIGHTEN REGULATIONS TO PREVENT DIGITAL BANK RUNS

The digitization of client-bank relationships changes the dynamics of bank runs, which requires the adaptation of some regulatory tools. For example, the liquidity coverage ratio is currently designed to bolster banks' resilience to deposit outflows. However, the period of time considered (30 days) is much greater than that of digital circulations, where deposit withdrawals can materialize at a speed of 40% in 24 hours. Additionally, when envisioning crisis scenarios, innovation in payments and digital currencies should be considered.

Action 3:?FINISH THE IMPLEMENTATION OF BASEL III.

The full implementation of Basel III must be faithful in all jurisdictions and entities of different sizes. This is a painful lesson from recent experience in the US, where the distinction between risks derived from large and midsize banks has proven to be a fallacy.

Action 4:?REDUCE OVERDEPENDENCE ON NATIONAL CHAMPIONS

The?"too big to fail"?problem resurfaced after a US giant had to step in to absorb the latest failing bank.

A more comprehensive banking union would further reduce remaining national barriers in banking systems and increase the options available to authorities when considering potential buyers for a troubled bank.

SYNTHESIS:

The recent turmoil in the banking sector has revived public attention on the vulnerabilities of the banking system. While euro area banks continue to show great resilience, we cannot rule out looming problems.

The culmination of the potential impact of exposed failures is essential to mitigate future bankruptcies.

The general European measures reduced the reliance of European companies on bank loans, as companies now have more options to obtain financing in the equity and debt markets.

CONCLUSION:

Moving forward with the capital markets union will allow for a greater choice of funding sources and, in turn, greater risk sharing away from the current bank-centric system, thus further reducing the impact that banking crises would have on the economy. economy.

Author: Diego Balverde

Economist, European Central Bank

[1] Federal Reserve (2023), Review of Federal Reserve Supervision and Regulation of Silicon Valley Bank.

[2] Definition: “A bank, insurance company, or other financial institution whose failure could trigger a financial crisis.”?

See also European Banking Authority for the definition of systemically important institutions: Systemically Important Institutions (europa.eu).

[3] Moral hazard: A party has incentives to take risks, knowing that they will be protected from the consequences of their risk or poor decision making, since these consequences will be borne by others.

[4] Federal Reserve (2023), Silicon Valley Bank Federal Reserve Supervision and Regulation Review.

[5] European Commission (2023), Reform of the banking crisis management framework and deposit insurance (europa.eu).

About the ESM Blog: The blog is a forum for the views of staff and officials of the European Stability Mechanism (ESM) on current economic, financial and political issues. The opinions expressed are those of the authors and do not necessarily represent the views of the MEDE and its Board of Governors, Board of Directors or Board of Directors.