In praise of banking regulation and supervision

Published on: 31 May 2023

When a number of regional US banks and Swiss giant Credit Suisse fell in rapid succession, fear of a repeat of the 2008 financial crisis rose. Fast-forward two months and the dust seems to have settled already. APG’s Maurice Walraven, credit analyst for the financial industry, and chief economist Thijs Knaap explain what's been different this time, and why Eurozone banks have escaped unharmed. "Regulation and supervision remain necessary to protect bankers from themselves."


Why have troubles in the banking sector not escalated into a full-blown financial crisis this time? A key difference is that in 2008 many banks had invested heavily in assets - particularly subprime mortgages - that proved essentially worthless. This time only banks with very specific characteristics have collapsed. One thing to note in this respect is that banks that bit the dust all depended to a relatively large extent on uninsured deposits for their funding. When interest rates started to rise, this vulnerability was exposed. "Once clients start to withdraw their money because they're no longer certain it's safe, such banks get into trouble very fast", says Maurice Walraven. Noteworthy too is that no banks in the Eurozone were brought down.


Have we really seen the end of banks collapsing suddenly?

Thijs: "Any bank that is confronted with an outflow of deposits becomes vulnerable, and such outflows are more likely to occur in times of rising interest rates. This is particularly the case in the US where money market funds offer an easy alternative for a savings bank and a 5 percent interest that banks can hardly match. In Europe, where the ECB has also increased interest rates to well above what you and I get on our savings accounts, this is also a risk. But mainly because alternatives are less easily accessible in Europe, we have not yet seen similar deposit outflows over here."

Maurice: "The general view among analysts is that the troubles in the US regional banking sector may not be over. Another characteristic of Silicon Valley Bank that is relevant with respect to potential future problems was its monoline business model, with a focus on a very specific group of customers. There are more such banks, particularly in Germany where a number of wholesale-funded banks specialize in commercial real estate. This sector has been under quite a bit of stress since the pandemic, so that is cause for some concern among investors. But at this point there are no signs that these banks are in any immediate danger." 


What are the reasons that no banks in the Eurozone have collapsed?

Maurice: "In large part that is because of differences in regulation and supervision between the US and the Eurozone. Whereas in Europe all banks under supervision of the ECB have to comply fully with the Basel III standards that were set in response to the financial crisis, that is no longer the case in the US. Banks with a balance sheet total of under 250 billion USD - like the three banks that have gone under - have been exempt from certain rules, as part of a deregulation program under the Trump administration. Also the ratio of insured deposits at the banks we talked about was much lower than at European banks where it is typically between 50 and 70 percent. And in addition, the ECB has put limits on the amount of interest rate risk in the banking book, something that their American counterparts have not done. That enabled Silicon Valley Bank in particular to carry a huge amount of such risk. And when interest rates started to rise faster and higher than they probably expected, that really exposed its weakness. So in my view these incidents are partly the result of failing bank supervision in the US, which is more fragmented and less strict than in the Eurozone."

"That's a key point we need to take away from this. Bankers always complain about regulation and supervision, but banking is an inherently risky business. Most bankers are very good at what they do and many can still remember what happened in 2008, but history teaches that regulation and supervision remain necessary to protect bankers from themselves. After the 2008 financial crisis a large package of new and stricter banking regulations has been put in place. The question is always at what point enough has been done. Are the dikes strong enough now to withstand the next wave? You never really know until the next crisis comes along. Now that everything seems to have stabilized again, I'm happily surprised that the dikes have held this time. It may not be fully over yet, but this could already have turned out much worse than it has. And yes, a price has to be paid for bank regulations and they will hurt returns in good times, but in bad times they are exactly what saves banks."

So far this has been a case of 'bad news is good news'

Does that mean no additional new regulations are needed this time?

Maurice: "One key difference between the events of the past few months and the previous crisis is the speed with which deposits can be withdrawn. The queues that formed on the streets in front of Northern Rock branches in 2007, you didn't see those this time. Nowadays you can move your deposits from one bank to the next with a simple click. It's not obvious how regulation could best prevent or slow down such a digital bank run, but it does call for higher liquidity coverage ratios, or the amount of liquid assets banks should hold to cover cash outflows. Klaas Knot, the president of the Dutch central bank, has also argued for this, and I fully agree with him on that. Another welcome addition is the strengthening of the EU's existing bank crisis management and deposit insurance (CMDI) framework that was recently adopted. This regulation has been in the works for years, so it was not developed in response to recent events, but the timing is very fortunate."


Have you seen or do you expect effects on the real economy?

Thijs: "That's a weird part of this story. One would assume that when banks get into trouble, the economy will suffer: lending is curtailed, uncertainty increases, companies and household postpone investments and purchases, and so on. But so far this has been a case of 'bad news is good news'. I'm not saying this crisis, if you can even call it that, has been positive, but the negative effects have been very limited. Investors quickly realized that this was not 2008 all over again and that the financial system as a whole would continue to function. They began to focus on the positives, the main one being that the pressure on central banks to raise interest rates further in order to combat inflation has eased. Once it became clear that problems were limited to a specific segment of the banking industry, stock indices and even bank indices quickly rebounded."

"Don't forget that while rising interest rates may have precipitated the downfall of a few regional banks in the US, high interest rates in themselves are good for banks. Once they survive a period of rising interest rates, banks can cash in on high rates. This is exactly what happened in the first quarter of 2023: US banks have posted record profits, and a number of Dutch banks have reported sharply increased profits as well."

The Collapse of Silicon Valley Bank - A Post-Mortem by the Fed


In a report published by the Federal Reserve, the supervisor is remarkably critical of its own oversight of Silicon Valley Bank (SVB). After calling SVB's failure "a textbook case of mismanagement by the bank", the Fed takes part of the blame itself. The bank's collapse was partially the result of “weaknesses in regulation and supervision that must be addressed. Regulatory standards for SVB were too low, the supervision of SVB did not work with sufficient force and urgency, and contagion from the firm’s failure posed systemic consequences not contemplated by the Federal Reserve’s tailoring framework,” the Fed writes.

The four key takeaways of the report are listed as follows:
1. SVB’s board of directors and management failed to manage their risks.
2. Supervisors did not fully appreciate the extent of the vulnerabilities as SVB grew in size and complexity.
3. When supervisors did identify vulnerabilities, they did not take sufficient steps to ensure that SVB fixed those problems quickly enough.
4. The Board’s tailoring approach in response to the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) and a shift in the stance of supervisory policy impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach.