By Professor Andy Mullineux
Emeritus Professor of Financial Economics
Over the weekend of 11 March, the US regulatory authorities took control of Silicon Valley Bank (SV), a Californian ‘regional’ bank, and the separately capitalised SVB UK was bought by HSBC for £1. In both cases uninsured, as well as insured, depositors were protected while bondholders and shareholders had their investments wiped out.
In an attempt to discourage a more widespread transfer of uninsured deposits from smaller regional banks to larger banks, the US central bank (the ‘Fed’) announced a special liquidity facility that allowed banks facing uninsured deposit outflows to borrow against the collateral of their US Treasury securities (bonds) valued at par (full value). Taxpayers are to be protected by a special levy on all banks by the FDIC (Federal Deposit Insurance Corporation); which insures deposits at participating banks. Notably, in contrast to the bail-out of the Irish banks in the 2007-9 financial crisis, the failed banks’ bondholders have not been protected and so the ‘bail-in’ bank resolution regime developed post crisis under ‘Basle Agreements’ has prevailed, along with ‘depositor preference’ amongst creditors.
The failed banks, and other regional banks facing uninsured deposit withdrawals in the US, enjoyed a more relaxed regulatory regime following the 2018 Bank Relief Law. The US regional bank bank liquidity crisis is a warning to the UK government, currently considering relaxations to the UK financial regulatory regime (the ‘Edinburgh Reforms’).
Why were the systemically unimportant SVB and SVB (UK) not simply allowed to fail with only insured depositors compensated? The reason seems to be that they were lenders to the strategically important fintech and wider tech sectors and the uninsured deposits included the business transactions accounts of tech companies. There were also sizeable venture capital fund (VCF) deposits; and VCFs are key sponsors of growth enterprises in the tech sector. The failed banks had highly concentrated loan portfolios by virtue of their specialisation and thus needed careful supervision and perhaps supplementary regulation.
Another lesson is that the US deposit insurance scheme needs an overhaul. It is hoped that capping protected deposits to $250k (deposits up to €100k are covered in the EU and up to £85k in the UK) gives an incentive for potentially very large depositors to spread smaller deposits around the banking system In the US, higher insurance premiums are charged on deposits with more risky banks, but, over 90% of the deposits at the failed banks were uninsured. Insurance cover should probably be extended to business operating balances for a suitable fee that discourages holding excessively large balances. In addition, Basle rules requiring the holding of liquid assets to cover uninsured (and ‘wholesale’) deposit withdrawals should perhaps be enhanced.
The problem in this case was that unexpectedly large deposit withdrawals could only be met by selling assets, the most liquid of which were government bonds. The price of these bonds has fallen as monetary authorities led by the Fed have raised interest rates aggressively in an attempt to reduce above target inflation rates. This would potentially force ‘fire sales’ of US Treasury bonds held by banks, imposing losses and absorbing regulatory capital; even though government bonds are ‘zero’ risk-rated in capital adequacy requirements. Regardless of price fluctuations during their life, bonds are redeemed at par on maturity, and the Fed’s special liquidity regime aimed to eliminate the need for fire sales.
The Fed’s prompt action, however, failed to prevent contagion, and other US regional banks came under pressure, particularly First Republic, along with Credit Suisse (CS), a large and already troubled European systemic bank. On Wednesday, the Swiss National Bank provided a substantial emergency credit line to CS, and on Thursday, eleven large US banks agreed, working with government and regulatory authorities, to place a substantial deposit with First Republic. Bank shares around the world, however, continued to fall and the Swiss financial authorities brokered a takeover of CS by UBS over the weekend of 18th March. As part of the rescue package, the ‘bail-inable’ (‘Alternative Tier 1’, AT1) bonds issued by CS were controversially wiped out to absorb losses and prevent a ‘bail-out’ call on taxpayers.
To some extent, the original problem has been self-correcting, since crises prompt ‘flights to quality’. Deposits moving from smaller to larger banks are initially invested in ‘US treasuries’. Additionally, the sizeable flows of uninsured deposits into US Money Market Mutual Fund investments, which are, ironically, uninsured and invested in US Treasuries, have driven up the prices of government bonds, and reduced their yields. The ‘unrealised losses’ on government bonds in bank portfolios have thus been reduced; but the threat to bank bondholders has increased.
To further reduce fire sale risk, central banks may need to reverse, at least temporarily, their ‘quantitative tightening’ policy of running down their bond portfolios that were built up through government and other bond purchases during ‘quantitative easing’; such as following the 2007-9 financial crisis, the Euro-crisis and in response the Covid pandemic. This is essentially what the Bank of England did by introducing a temporary facility to purchase government bonds at par from pension funds, which experienced an acute liquidity crisis as bond prices fell and yields rose following the autumn ‘mini-budget’.
The central banks are now facing market pressure to limit planned interest rate increases in case there are other hidden fragilities in the banking and wider financial systems. Resuming government bond purchases to bolster bond prices might allow them to stay the course of increasing interest rates to bring down inflation; but would exacerbate yield curve inversion, which is deemed to be recessionary. The crisis of confidence in the banking system has not yet abated and so banks can be expected to reign in lending, further exacerbating the recession. To resolve the 2007-9 financial crisis, bondholders had to be bailed out at the expense of taxpayers. Will taxpayers be spared this time?
A further lesson for the monetary authorities is that they can only apply the monetary brakes to curb inflation if the financial vehicle is in good condition. Hence central banks should have responsibility for both financial and monetary (inflation) stability. Unfortunately, they lost control of inflation, in part due to unforeseen events, such as the Covid pandemic and the Ukraine War. But they seemingly also maintained low interest rates through quantitative easing for too long, allowing distortions to become embedded in financial systems.
In the US, fragility seems to have been aggravated by relaxing regional (‘non-systemic’) bank regulation. A more cautious approach to the post-Brexit regulatory liberalisation being considered for the UK’s banking and capital market sectors now seems warranted.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of the University of Birmingham.