What caused the proliferation of bank collapses in the U.S. and how did their consequences extend to other countries and banks? Is this reminiscent of the global financial crisis of 2008?
The root of the current situation can be traced back to the bankruptcies that hit several American banks, with far-reaching effects on banks outside the U.S., particularly in Europe.
Three major U.S. banks – Signature, Silvergate Capital Bank, and California-based Silicon Valley Bank – declared bankruptcy within a week, making it the largest bank failure since the 2008 financial crisis. This sent shockwaves throughout global financial markets.
As soon as bankruptcies were announced, speculation that history was repeating itself and that the 2008 crisis was about to engulf the world once more began to circulate. This was compounded by the challenging situation faced by the prestigious “Credit Suisse,” which required a government rescue plan to prevent its collapse.
Let’s examine what occurred in 2008. In September of that year, the crisis erupted with the announcement of the bankruptcy of U.S. bank “Lehman Brothers,” triggering a banking and financial meltdown that was later regarded as the most severe since the Great Depression of 1929.
The crisis initially began in the U.S., but it spread to many countries around the world. In 2008, the number of banks that failed in the U.S. was 19, and it was anticipated that more failures would occur among the remaining 8,400 or so American banks.
Read more: Could these 2 banks be the next to fail in the US?
Is this a repeat of 2008 but with a modern-day format?
The current situation cannot be considered a sequel to the 2008 global financial crisis. In response to that crisis, a regulatory system was established, designating the world’s major investment banks as “too big to fail” and requiring them to hold significant amounts of cash or liquid reserves to survive any future financial turmoils.
The reasons behind the current collapse of US banks are apparent, and they are closely linked to the Federal Reserve’s hawkish policies. The Federal Reserve raised interest rates in an attempt to control inflation, which had risen to extremely high levels.
U.S. banks accumulated substantial deposits during the pandemic and invested a large portion of their inflated portfolio of deposits in low-risk Treasury Bonds, but failed to implement adequate preventive measures. This exposed them to interest rate risk, as the rising interest rates eroded the value of their long-term bonds, as in the case of Silicon Valley Bank.
As interest rates increased, the value of long-term bonds held by U.S. banks decreased due to their inverse relationship with interest rates. This resulted in significant losses, which were further compounded when bank depositors made substantial withdrawals.
The banking crisis spread to Europe, specifically to Switzerland, where Credit Suisse faced significant setbacks and a decline in its share price, prompting authorities to intervene to save it.
Although the difficulties faced by the Swiss bank differed from those of Silicon Valley and Signature banks, Credit Suisse’s troubles heightened concerns about the overall economy.
Why did this happen?
The current crisis can be attributed, in part, to the mismanagement of asset and liability risks by bank officials, which has resulted in a rapid decline in depositors’ confidence.
Silicon Valley Bank, in particular, took on excessive risk, as it was not subject to the same level of regulation as other major U.S. banks that adhere to Basel III standards. This lack of regulation was a key contributing factor to the current predicament.
In 2018, then-U.S. President Donald Trump passed a liberalization law that exempted thousands of small banks from strict regulations and relaxed the rules that large banks had to follow. Under this law, the asset limit for “significant financial institutions” was raised from $50 billion to $250 billion.
However, Silicon Valley Bank was not subject to stricter regulations that applied to top-rated banks because it was not classified as a significant financial institution.
In other words, Silicon Valley Bank was able to invest billions of dollars of its deposits in U.S. Treasuries without having to hold sufficient reserves to protect client funds, should markets move against the bank’s interests. This was due to the bank not being subject to the stricter regulations of Basel III standards, unlike other major U.S. banks.
After the 2008 financial crisis, banks were required to maintain 100 percent liquidity coverage, meaning they must hold enough high-quality liquid assets to finance cash outflows for 30 days. Treasury Bonds were among the assets that banks could hold for liquidity purposes. However, with the Federal Reserve raising interest rates continuously since last year, the value of older, longer-term bonds has fallen, causing significant losses for bondholders.
The repercussions of Silicon Valley Bank’s collapse have increased credit risk globally, as investors fear further failures in corporate debt markets.
The situation creates a “moral hazard” in economics, where a bank or investor has an incentive to increase financial risk because they are shielded from the potential consequences of it.
Many economists argue that moral hazards in financial markets increase the risk of harmful economic activity, while others believe that maintaining incentives to reduce financial exposure can help markets avoid excessive and reckless risk-taking.
Stress tests
Thus, it is crucial that central banks and regulatory bodies carefully consider the potential repercussions of their policies, especially when it comes to raising interest rates. The Federal Reserve’s recent tightening policy has already caused U.S. banks to suffer unrealized losses of $620 billion from yet unsold assets that have lost value, according to data from the Federal Deposit Insurance Corporation.
These events underscore the importance of accountability for central banks and regulatory bodies when it comes to hedging risks and preventing crises before they occur. Laws related to banks, such as stress tests, must be strictly enforced to ensure that institutions are adequately prepared for economic and financial shocks.
Stress tests are essential tools for banks’ risk management and are among the most important precautionary safety measures at both the macro and micro levels in the banking sector. They provide a snapshot of a financial institution’s ability to withstand difficult scenarios, allowing regulators and managers to assess their resilience and take appropriate measures such as capital consolidation, procedural modifications, and advanced contingency planning.
In times of uncertainty, risk management is paramount.
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