Can changes made after 2008 protect us from another financial crisis?

The recent panic in financial markets began with the collapse of Silicon Valley Bank (SVB), the largest to collapse in the US banking sector since 2008.  More aware of the stakes, the US authorities quickly organized the orderly liquidation of SVB, and the Fed has also committed to lending necessary sums to other troubled regional banks on favourable terms.

Yet the banking crisis 2.0 has quickly crossed the Atlantic. Its greatest victim to date is none other than Credit Suisse, one of the giants of European banking and one which had never really recovered from the financial crisis of 2008-2009.

The rescue organised by the National Bank  of Switzerland and the regulator led to the takeover of the bank by its major competitor UBS. Banks control the flow of credit which impacts the functioning of the real economy and real consumers. In April, the European Central Bank will publish quarterly credit indicators which will give us the first signs of how the crisis is impacting the volume of credit available to businesses and consumers at ground level.

The emergency commando operation in Switzerland has reduced the tension on the markets and in various European capitals. It also avoids the collapse of the Swiss banking system and the exposure to systemic risk that would have led to a global financial crisis and plunged our economies into recession.

Banks are particularly susceptible to such systemic risk as they are much more interconnected than organizations in other economic sectors. Credit Suisse was one of these ‘systemic banks’ – a bank whose size is such that a bankruptcy would lead to the bankruptcy of other banks, of the banking system and the economy in time. The merger with UBS creates an even larger and and therefore even more systemic banking group. We see this clearly with Credit Suisse where the presence of good ‘prudential ratios’ as required by Basel III,  were not enough to prevent it having to be rescued to avoid a domino effect across the sector.

These prudential ratios alone cannot ensure the soundness of the system – they do not help in the case of investor panic (where banks stop lending to each other) or saver panic (a bank run). In the case of Credit Suisse, the panic started to rise when a shareholder announced they would no longer invest in the bank.

The biggest risk to the banking sector comes from rising interest rates.  The European Central Bank recognised the inflationary risk too late meaning it had to raise its rates quickly and sharply.

Since banks are required to hold safe assets on their balance sheets, they hold a lot of sovereign debt. However, faced with very high inflation, Western central banks had no choice but to sharply increase their key rates, which had a very significant impact on bond yields.

This translates into significant losses on banks’ bond portfolios. Since the beginning of 2021, European 7-10-year sovereign debt has lost about 18% of its value. On maturities that exceed 10 years, losses approach 30%.

Banks are therefore sitting on huge losses on their bond portfolio but, a priori, without this having a negative impact on the accounts, since they keep these assets on the balance sheet in a logic of price-to-maturity, that is to say, assuming that they will keep these assets until maturity and will continue to collect their coupons until then.

On the other hand, when for one reason or another, a bank is in difficulty and runs out of cash and has to part with these assets, it takes the loss immediately, leading to capital increases that are poorly received on the stock market, which give a clear sign of weakness in the eyes of investors.

With the takeover of Credit Suisse by UBS, the Swiss authorities are opting to create a new banking giant in Europe. We do not believe that this type of transaction is likely to reduce the level of risk in the European banking and financial system.

In the current environment of persistent and even increasing risks, we believe that the authorities need to consider decisions of a different nature. Banks need to be smaller because the fall of a small bank will do less damage than that of a large one.

Their balance sheets need to be more transparent and the most complex/speculative financial products need to be better regulated or even banned.  Finally, the implementation of Basel III must be completed as soon as possible.