Importance of Capital and Regulatory Framework
The ongoing pressure on the global banking sector sparked by the failure of Silicon Valley Bank (SVB) is raising questions about a possible repeat of the crisis of 2008, not helped by the addition of Credit Suisse to the equation. The contagion in the wake of SVB is spurring calls for US regulators in particular to adopt Basel rules around the interest rate risk in the banking book (IRRBB) that were put in place post-2008, which many believe would have flagged problems at the affected banks much earlier and allowed regulators to act, possibly even saving the banks. Moreover, it questions the Fed’s tailoring act of 2019, which raised the thresholds for banks to adhere to certain prudential metrics (primarily based on total assets, short-term wholesale funding, non-bank assets and off-balance sheet exposures). This resulted in mid-size banks (<$700 Bn) not needing to comply with most of the advanced Basel regulations.
But today’s crisis is a different animal to its predecessor. SVB and others were hit after central banks raised interest rates following a long period of low or even negative rates. The banks had invested in long-term assets with a fixed rate or larger fixed components. When rates rose the value of these assets plunged, creating either virtual losses in a held-to-maturity portfolio or a loss in equity for available-for-sale assets.
SVB’s portfolio had a reverse correlation with the interest rates, so that, as deposits increased on the liability side, the assets it held either stayed fixed or grew at a much slower pace. What started as an exposure to interest rate risk quickly impacted longer term value measures such as EVE (Economic Value of Equity). When deposit holders started withdrawing money this caused a negative spiral.
The banks impacted by the fallout from SVB situation can attribute their woes to one or more of three main factors. In some cases, they were warned of their exposure to a rise in interest rates by internal systems but chose to ignore them, in a case of mismanagement. In others, there were instances of fraud or financial crime that dragged them into a negative spiral. Or it could have been a case of managers acting rashly and taking bad decisions without access to all the metrics they needed, thereby turning an operational risk situation into a financial risk.
While the involvement of Credit Suisse is attracting headlines around the globe, it’s also important to understand that the problems at SVB, Signature Bank, First Republic Bank and Credit Suisse are unrelated. Prior to SVB there had been a string of substantial deposit withdrawals from the Credit Suisse bank in the last quarter, which were compounded by the bank posting the largest loss since the global banking crisis, resulting in a plunge in the share price that meant more financing was needed to keep Credit Suisse afloat.
But in Credit Suisse’s case, the regulator confirmed that the bank met the liquidity and capital requirements linked to systemic important banks, suggesting that this was a failure of trust with depositors withdrawing money due to earlier scandals and compliance failures at the bank, which spread to investors who declined to provide further funds.
UBS’s acquisition of Credit Suisse is an effort to restore that trust in order to calm down investors and the market, although the European Central Bank’s recent 50bp interest-rate hike of course did not help the situation as it devalued bank holdings in long-term issues. But as a result of the regulatory measures taken post-2008, financial institutions are well capitalized on the whole, so the overall impact should be limited.
So, if Credit Suisse is unrelated and SVB is a case of mismanagement, why are US regulators taking the heat for SVB?
While Europe has moved to tighten rules over the course of 2023 as part of the adoption of the Basel Framework, the US regulation did not mandate the banks to be compliant with these regulations just yet. Further, the introduction of the tailoring act, which resulted in mid-tier banks not requiring to comply with the more advanced Basel Capital and Liquidity metrics (incl. IRRBB) has led to decreased scrutiny by regulators even if they wanted to. It could be argued that banks, such as SVB, which have experienced very rapid growth over the last few years, were missing a robust internal control over their balance sheet and could have benefited from such a regulatory framework. Market actors’ consensus suggests that if the banks affected by SVB had been subject to IRRBB, the huge interest rate risk they were carrying would have been identified earlier, and flagged to a regulator who could have acted to address the issue, potentially saving the bank in the process. The recent events could give rise to a momentum in the house to revise this tailor act.
Many saw the writing on the wall but chose to ignore. Agreed that with many uncertainties and a dynamic regulatory landscape, choosing the path forward by itself is complex. Having said that, there’s never a perfect time to make the right investment in technology that futureproofs your organization for the known and unknown. So, what should banks take away from the SVB debacle, and what measures should they be taking now to mitigate against similar shocks?
- It is vital for mid-size/tier banks that have experienced rapid growth over the past few years to ensure they have built a robust internal balance sheet management system to identify critical gaps on their balance sheet.
- Furthermore, they will be able to run simulations that in times of uncertainty, will enable them to apply a holistic risk management framework, which will assist the bank when a crisis appears. While supporting business as usual, they will have the ability to recognize and act quickly when an event occurs.
- In an everchanging and dynamic regulatory landscape, the ability to use regulatory metrics further constrains the internal risk management system and ensures regulatory compliance at all times while optimizing it from a risk perspective.
Such an approach gives financial institutions the ability to use what they want to do while being assured that they are in line with what they must do.