From the perspective of risk managers in banking the world over, it has been fascinating to witness the rise and subsequent decline of cryptocurrency, a proposed alternative monetary system that depends on mass consensus and decentralisation to authenticate transactions. The idea that large swathes of the population would prefer thousands of computer geeks in disparate locations to run the world’s financial system, rather than simply trusting the existing system, speaks volumes about the destruction of public trust in banking.
The problem can be traced back to the relentless failure of banks across the globe, and the inevitable bailouts that ensue. In light of this, it would appear that mass cognitive dissonance persists in the risk management fraternity, as banking regulators, risk officers and governments have continued to impose ever more complex and onerous regulations on the banking industry since the 2007/08 Financial Crisis. Clearly, these regulations have not worked, and have inadvertently made banking more prone to failure, not less. In fact, it is only through extensive government intervention that wider contagion and more bank failures have been avoided.
As a direct result of the Financial Crisis, 106 of the largest 1000 banks that existed in the world in 2007 failed. More than a decade later, despite all that had been learned, three of the four largest bank failures in US history occurred in rapid succession, triggered by the collapse of Silicon Valley Bank (SVB). A few weeks later, Swiss-based megabank Credit Suisse also failed.
Just three months after SVB’s collapse, the US Federal Reserve released the results of its annual stress tests, stating confidently that the US banking system remained “strong and resilient”. Even in a “doomsday economic scenario”, noted the Financial Times, the tests proved that the US banking system was prepared for any eventuality. The economic assumptions of the doomsday scenario included US unemployment reaching 10% and a 40% decline in commercial real estate (CRE) values, although the 23 banks that met the minimum balance sheet requirement for annual stress testing – raised from $50 billion to $250 billion in 2018 – held only 20% of all CRE assets. The Fed’s scenario also assumed that it would cut interest rates to almost 0% to ease the pressure of the downturn. Given that the 2023 stress tests results were released in June, when the Fed was still hiking interest rates, this “doomsday” scenario seemed particularly disingenuous, since these annual scenarios are meant to materialise in the short term, yet rates were still increased in the following months.
Buoyed by the results of the tests, many of the largest US banks notified their shareholders that they would be increasing their dividend payments, since they were now technically overcapitalised. This included Bank of America, which by early 2023 had amassed $100 billion of unrealised losses in its bond and mortgage-backed security portfolios, representing one-fifth of all unrealised losses in the US banking system. Under the contentious mixed measurement accounting approach, unrealised losses on security portfolios have no impact on a bank’s income statement or balance sheet if they are classified as held-to-maturity. In June 2023, the unrealised losses in the US banking system amounted to $515 billion – roughly equivalent to the total credit and trading losses the Fed’s doomsday scenario predicted. Recall that it was the loss of faith in SVB’s management that led to sudden withdrawals, forcing the bank to sell a significant portion of its bond portfolio, incurring losses that led to its sudden death. SVB’s failure triggered the most severe banking crisis since 2008, yet, in the Fed’s 2023 “doomsday” scenario, this risk was nullified by the assumption of near-zero interest rates, theoretically curing the bulk of these unrealised losses at the banks being tested.
Since the Crisis, the Fed – the entity responsible for monetary policy in the largest economy, home to the world’s de facto fiat reserve currency – has also printed extraordinary amounts of money. Between 2020 and 2022 alone, the Fed more than doubled the size of its balance sheet from $4.2 trillion to $9 trillion. Then, in March 2022, having underestimated the extent of the inflation that inevitably followed, it implemented a series of rapid interest rate increases. The result was the destabilisation of currency markets across the world, the export of inflation, and some of the largest ever bank failures.
History has repeatedly demonstrated that central banking is vital for the sustainability of sophisticated economies globally. The conundrum of central banks is that their role in bringing order to the potential chaos of the financial world is necessary, as is their intervention in manias, crises and panics, but it is a role that is beset with difficult decisions and unintended consequences, which have the power to erode public trust in the financial system as a whole, as is witnessed at present.
To restore trust, US banking regulators need to align more closely with their European counterparts, a better balance must be achieved between the desire for sufficient capital buffers and for banks to be able to produce attractive returns on equity, and the Fed’s stress testing regime should be revised. At a minimum, stress-testing scenarios should be defined by an institution that is independent of the Fed and designed to be more globally oriented, rendering them more useful to the international banking system.
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Monocle is an independent, results-focused management consulting firm specialising in banking and insurance, with offices in London, Amsterdam, Johannesburg and Cape Town. As industry thought leaders, we remain at the forefront of risk management news and trends to best serve our valued clients around the globe. To find out more, visit www.monoclesolutions.com.
In the endeavour to stay ahead of the curve on industry insights, Monocle’s CEO, David Buckham, has recently published his latest book, titled Why Banks Fail: Unrelenting Bank Runs, The Conundrum of Central Banking, and South Africa’s Place in the Global Order. For an insider’s perspective into why banks fail and how the industry can evolve to become more resilient, search for Why Banks Fail by David Buckham on www.amazon.com.