Calming the storm after the SVB collapse: Robust prudential policy the key to financial stability

Where are we?

Further to our previous article, the collapse of Silicon Valley Bank (SVB), Signature Bank and Silvergate Bank in the last week has caused turmoil in the global financial market. Fear and panic – exacerbated by a social media age and 24-hour news cycle that have taken hold since the Global Financial Crisis (GFC) – have centered on the prospect of widespread bank runs on small- and medium-sized enterprise (SME) lenders carrying similarly high levels of unrealized bond losses. 

Banking regulators globally are now assessing contagion risks for local banks, and have flagged their willingness to provide liquidity support for any banks caught in the global headwinds. The focus of regulators in the last few days has turned towards so-called ‘globally systemically important banks.’

Whatever way you look at it, the global financial system is facing yet another moment of fragility – following the UK pension fund crisis last year, the collapse of FTX and the ripple impact of crypto failures worldwide, and the China real estate crisis, among other major ‘shock’ events in the past 12 months.

The false demonization of monetary policy

Many have been quick to say that the current crisis is a result of over-zealous monetary policy. A majority of lenders have enjoyed record deposits as customers accumulated significant savings during the pandemic years – with many banks taking on more deposits than they could lend out to borrowers. The surplus cash was used to invest in traditionally safe and high-quality government bonds, which promised good returns when interest rates were low.  

But interest rate increases caused bond prices to crash, leading to unrealized losses (yet to crystallize so long as banks intended to retain the bonds to maturity).  

In the case of SVB, Signature and Silvergate, the losses were realized from mass bank runs that resulted from a combination of high inflation, declining business confidence and limited access to new finance. Those macroeconomic factors led customers to tap into their deposits as a source of ongoing working capital. 

The current crisis has been set up by many as a fight against inflation versus a fight to save the stability of banks and the financial system more broadly. 

But this is a false dichotomy. A broader reference point is needed.

The importance of sound prudential policy in ensuring financial stability

Banks globally are facing the same key macroeconomic pressures. After years of ultra-low interest rates, bond yields have increased substantially with rising rates, eroding the value of banks’ underlying assets.

But not all banks automatically face the same risk of collapse as SVB, Signature and Silvergate. 

For larger banks, regulations in most nations are consistent in requiring banks to undertake periodic stress tests, to hold a minimum amount of cash on their balance sheets to protect against shocks, and in some cases to also specifically hedge against downside risks from losses on bonds and other assets. These banks will not face the same level of exposure if they are hit by sudden bank runs on deposits.  

Yet for SME banks, the key issue in the United States was that the protections of Dodd-Frank regulations were scaled back in 2018 – so that banks with assets under US$250bn no longer needed to submit to stress testing, and could carry fewer capital reserves on their books to cope with adverse financial shocks. These exemptions were designed to enhance the flow of capital in the SME market – especially in the tech and start-up space that came to be dominated by SVB and its customers.

Of course, one can have too much of a good thing. These relaxed prudential standards mean that banks in the United States are now carrying, on some estimates, as much as US$620bn of unrealized losses from bond holdings. For SME lenders, there has been minimal hedging against these losses, and there is not the balance sheet resiliency to deal with hits on deposits. The Federal Reserve’s new Bank Term Funding Program – announced in the days after the original collapse of SVB – may be called upon by a number of SME banks in the United States as the current crisis continues to rapidly evolve. 

What we are now seeing play out reinforces the need for sound prudential regulation and supervision in the good times, not just the bad times. The idea is to require banks to have in place adequate buffers by strengthening their capital and liquidity positions.  

However, beyond capital adequacy, stress testing and hedging requirements, there will also be a need for prudential regulators to develop new standards for broader risk management by banks (as well as insurers). In a rapidly transitioning economy, and with the proliferation of an advanced digital age, these requirements will need to cover cybersecurity controls, anti-money laundering and financial crime risks, and exposure and stress testing in relation to climate and biodiversity risks. 

Collectively, robust prudential standards ensure resiliency and sustainability in the financial sector, and the ability to navigate periods of extreme stress. 

And ultimately, as the Bank for International Settlements (an international financial institution which facilitates cooperation between, and acts as a direct bank for, 63 central banks representing 95 percent of the world’s GDP) has identified; stronger prudential frameworks ultimately work in tandem with monetary policy. They ensure that the financial system is better able to withstand interest rate increases designed to control inflation – limiting the pressure on banks from the crystallization of bond losses, as well as bank runs from customers facing working capital and cost of living pressures.

Takeaway

To label the current crisis as one resulting from over-zealous monetary policy may be misconceived. Rather, it is a lesson in the need to design and implement effective prudential regulatory and supervisory frameworks, which are consistent and coordinated across different jurisdictions.  

Since the GFC, domestic prudential regulators – such as the Federal Reserve Board and the Federal Deposit Insurance Corporation in the United States, the Australian Prudential Regulation Authority in Australia, the Prudential Regulation Authority in the United Kingdom and the European Banking Authority in the EU – and global standard setting agencies led by the Basel Committee and the Group of Central Bank Governors and Heads of Supervision, have sought to enhance these regulatory and supervisory frameworks. The intention was to never again have ‘another Lehman Brothers moment’ by ensuring robust rules on capital and liquidity management, as well as broader systemic risk management practices.

As the ripple impact continues to be felt across the world from unfolding events, these new regulations will be properly tested for the first time – and their effectiveness in supporting the stability of the financial system will become the key focus point in the global economy for the foreseeable future.