May 20, 2023

Lessons from US banking crisis

Another bank, the Francisco-based First Republic Bank (FRB), has been acquired by JP Morgan Chase, further escalating the US banking crisis. Although all of the depositors of the three US banks affected by the crisis are safeguarded, it is important to comprehend the specifics of how the problem came to be. The Federal Deposit Insurance Corporation (FDIC) protects depositors in US banks, with the exception of high value deposits exceeding US $ 2,50,000. However, it is challenging to make up for the collateral harm the crisis has produced. The US banking stress even stretched to Europe where UBS a large bank had to bail out – once a giant bank – the Credit Suisse. 

In a similar way, stock market declines that result in investor wealth loss, deposit withdrawals from numerous other banks that force banks to sell their investment portfolios at a loss, business disruptions to numerous interconnected market constituents, etc., can cause significant harm to financial entities. Such a banking or financial crisis hurts various industries, subduing the value of many businesses' stakeholders. 

When Yes Bank was on the verge of bankruptcy in 2020, RBI quickly intervened by calling stronger banks and financial organisations to come to its aid and implementing a successful revival plan. 

Broad reasons for banking crisis: 

Information in the public domain points to a few distinct causes for the development of the US banking crisis. It is the way banks balanced risks during the era of ultra-low interest rates amid excess liquidity and how the assets and liabilities management (ALM) plan was carried out. As lending demand declined due to a decline in economic activity, easy money found its way into deposit growth. Due to the fact that many businesspeople who could have been bank borrowers were still dealing with the effects of the pandemic, banks had large levels of liabilities and low levels of loan book. 

In the context of how the crisis developed, FRB's business strategy was centred on high-net-worth clients and had a significant amount of uninsured deposits. When interest rates were dramatically increased to combat inflation and yields declined, the value of the loans and investments decreased. This made it challenging to raise funds. Gross unrealised losses in the portfolio of investments held to maturity increased from US$53 million to US$4.8 billion by December 2022. The market realised that FRB's notional losses had reached a height of US$13.5 billion, which had caused its decline. Furthermore, because half of its loan book was made to a single family for residential mortgages, it was challenging to offload such a concentrated credit risk. The sources of revenue were not sufficiently diverse.

Review by US Federal Reserve: 

The US Central Bank examined its supervision and regulation after SVB's demise to determine the causes of the banking crisis. It found that SVB accumulated a lot of highly concentrated business but was unable to control the risks involved. Its board and senior leadership failed to implement effective risk governance. In spite of the bank's rapid expansion in size in the years preceding its demise, it was unable to control basic interest rate and liquidity risk. SVB maintained a high rating despite the fact that its conditions were getting worse and even though there were obvious hazards to its safety and soundness. 

Better risk management was not being encouraged by any institutionalised procedure, and reward was based on short-term gains and a spike in stock prices. The bank was rapidly expanding during the year that the chief risk officer (CRO) was absent. Technology and social media's quick spread hastened bank failure within hours, leaving banks with no time to find other arrangements to meet liquidity requirements.  It also discovered several oversight and regulation flaws, as well as a lack of urgency and appropriate force. The central bank refrained from punishing bank management. These three banks share a single phenomenon. Despite being recognised as universal banks, they evolved into specialty banks focused on a certain clientele.

SVB placed its bets on high-net-worth people, IT firms, startups, and venture capital organisations. The goal of Signature Bank was to provide personalised service to a small number of high-net-worth clientele. It quickly diversified to operate in the cryptocurrency industry, strengthening ties to high-risk crypto businesses. Large loans were offered at lower rates by FRB, while large mortgage loans received preferential rates. 

Missing risks led to banking crisis: 

The government, banks, and regulators were all aware that the rising interest rates needed to decrease. Bond yields will decline, causing some institutions' investment portfolios to contract. The extra liquid will be soaked up. Therefore, the information that was accessible regarding the banking crisis clearly showed the gaps in risk management by giving priority to short-term business growth and earnings without properly implementing stress tests and visualising

To better manage risks, banks' internal capital adequacy assessment policies (ICAAP) need to set a dynamic risk appetite that is in step with the market environment. In periods of low interest and high liquidity, appropriate risk management procedures were not implemented, leaving banks exposed to risks that many people later found to be unsustainable. In times of easy money, risk management procedures must be more stringent to be ready for difficult times. 

Market players, academic institutions, research organisations, policy makers, and other important stakeholders should draw lessons from the US banking crisis in order to identify the shortcomings and publicly communicate the learning points to ensure that similar disasters do not occur again. By establishing checks and balances and other safeguards, the regulators and banks can collaborate to ring fence the financial stability.


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