Regulatory Responses to This Year’s Bank Failures

Sebastian Sohn discusses the lessons learned from bank failures this year and the supervisory and regulatory changes we can expect as a result. 

In March this year, four large banks failed or had to be rescued, following a year of steep interest hikes. This included institutions such as Credit Suisse, First Republic Bank and Silicon Valley Bank.

While each bank failed for institution-specific reasons and management errors, there have been similarities across all four cases:

  • losses on long-term fixed-rate assets,
  • loss of trust among clients and investors,
  • withdrawals of deposits (particularly uninsured deposits), and
  • an unexpected speed and size of bank runs, facilitated by technology and social media.

Unlike during the Global Financial Crisis, this year’s bank runs didn’t produce pictures of long queues of worried depositors. Withdrawals happened almost instantly, and banks failed within just a few days. In 2007, it took four days for an outflow of 20% of Northern Rock’s deposits; in 2023, Silicon Valley Bank’s lost 85% of its deposits in half of that time.[1]

As the risks to the wider financial system seem to be contained, regulators and standard setters are reviewing the root causes of the recent events and drawing conclusions. As seen in the aftermath of previous crises, increased supervisory scrutiny in the short run will possibly be succeeded by regulatory changes and readjustments in the future.

Bank failures happen when macroeconomic headwinds meet idiosyncratic weaknesses

On the systemic side, rapidly rising interest rates led to a declining market value of fixed-rate and other assets. The Fed’s Funds effective rate rose from 0-0.25% in January 2022 to 4.5-4.75% in February 2023, and it continued to rise to 5.25-5.5% at the time of writing. Just 3 years ago, many expected a continuous low interest rate environment: the Fed experts’ June 2020 projection suggested a long-term Fed funds rate between 2% and 3%, for instance.[2]

While this environment has been challenging for many banks, BCBS and FSB identified a set of common weaknesses among those who failed: deficiencies in management and board oversight, a questionable business model with unhealthy growth and short-term focus, shortcomings in the “basic risk management of traditional banking risks” (BCBS) including interest rate, liquidity and concentration risk, combined with a lack of awareness of compounding effects across risk types. Those shortcomings coincided with short-term incentives for management and lack of responsiveness to supervisory interventions.[3]

The bank failures in the US had a relatively minor direct impact on the banking system in Asia.[4] However, the supervisory “lessons learned” and potential regulatory changes will also affect institutions in this part of the world.

Regulatory changes for liquidity and interest rate risk and AT1 expected

While FSB and BCBS emphasize the functioning of Basel III in preventing a bigger contagion in the wider financial systems, they discuss the potential need to recalibrate existing standards and practices under both Pillar 1 and 2 and to increase global coherence in supervisory practices and the application of proportionality principles:[5]

Liquidity risk

The Liquidity Coverage Ratio (LCR) was introduced to measure and monitor banks’ liquidity resilience over a time horizon of 30 days. It contains prescribed deposit run-off rates implying a (at that time conservative) stress scenario while assuming virtually unrestricted accessibility and fungibility of high-quality liquid assets. This year’s events raised questions about their effectiveness though, which also applies to the NSFR (to a lesser extent). The BCBS refers to ongoing discussions about a rebalancing of the LCR’s objective by shifting the focus from a 30-days perspective to “buy(ing) enough time for authorities” to intervene. Other suggestions include new indicators such as a liquidity ratio with a 5-day perspective as well as an unweighted liquidity ratio.

Interest rate risk

Interest rate risk in the banking book (IRRBB) is currently captured under Pillar 2 with corresponding disclosure requirements under Pillar 3 (not applicable to the failed US banks). The model prescribes interest rate shocks between 150 and 300 basis points for USD positions which contrasts with the actual interest rate hikes seen in recent years. Discussions evolve around a higher granularity, increased international coherence of its application and a move to capture IRRBB under the Pillar 1 standards.[6]

Regulatory capital

In its reflection on the Credit Suisse crisis, the Swiss National Bank observed deficiencies in the effectiveness of AT1 capital in a going concern scenario.[7] This experience is echoed by the BCBS and may lead to a broader review of AT1 capital, also considering observed expectation mismatches between issuers, supervisors and investors as well as characteristics of AT1 instruments and creditors that differ significantly across jurisdictions[8]. This coincides with other discussions around a redesign of AT1 in general, including in a Financial Stability Institute working paper issued in September[9].

Other observations concern accounting classifications – namely the impact, or the lack thereof, of unrealised losses of held-to-maturity positions on banks’ capital position. Supervisors and regulators will continue to explore ways for preventing unintended or arbitrary side effects of accounting decisions on regulatory ratios.

Banks need to brace for supervisory and regulatory changes

In the short run, banks will need to expect increased supervisory scrutiny with a focus on affected risk types, governance and control systems.

In the long run, there is a possibility for changes and adjustments under Pillar 1 and other elements of the prudential framework.  Although the BCBS emphasises that ongoing discussions do not indicate planned revisions to the Basel Framework, history shows a correlation of bank turmoils (e.g. Savings & Loans Crisis, Asian Financial Crisis and Global Financial Crisis) and subsequent regulatory responses (Basel Accord, Basel II and Basel III, respectively).

Momentum for tighter regulation

Some Asian jurisdictions, especially Singapore, are among the frontrunners in adopting the finalised Basel III standards according to BCBS’ latest RCAP.[10] However, the momentum for regulatory change might have faded in Western jurisdictions over the years: deviations from the finalised Basel III rules in the EU might halve the actual capital impact from the output floor, for instance.[11] This might even be true on the global level: the originally proposed fundamental changes to the CR-SA and a separate “broader holistic review of sovereign-related risks”[12] led to a rather evolutionary CR-SA revision in the finalised Basel III standard in 2017 after consultations and negotiations.

However, crises make weaknesses in regulatory frameworks transparent. This tends to increase policymakers’ willingness and the public’s acceptance for tightening regulation – regulatory changes in the upcoming years are a real possibility.

Enhanced regulatory reporting

A potential starting point could be the introduction of more granular and more frequent regulatory reporting, e.g. on liquidity and interest rate risks. Such ideas had already been floated in the regulatory community: a 2020 FSI working paper discusses “on demand” versus “point in time” reporting as well as “data sharing” concepts. This would supplement or even replace report submissions with an option for authorities to access and extract data from financial institutions’ systems.[13] The FSB also described similar concepts in the context of the future of supervisory technology.[14]

Some regulators in the APAC region have already taken steps to modernise their reporting infrastructure.[15] The MAS had developed considerable expertise in and experience with AI[16]. APRA even re-prioritised granular reporting roadmaps to cover this year’s focus areas[17].

What banks need to do now

Banks and bank supervisors have stepped-up their focus on interest rate, liquidity and concentration risks. Beyond these essential short-term measures, banks are well advised to review and improve their risk exposure and management in other areas and anticipate regulatory and supervisory developments. This may include inter alia:

  • reviewing and enhancing the risk culture: a focus could be increasing awareness of black swans and grey rhinos which may not be fully quantifiable or implementable in models,
  • addressing organisational weaknesses and shortcomings – whether it’s governance, controls or remuneration and incentive systems,
  • reviewing and improving the data architecture as well as the availability and quality of data –for management purposes as well as future regulatory/supervisory requests,
  • following or participating in discussions around AT1, assessing different scenarios for future regulatory capital composition and potential responses.

Conclusion

This year’s events have proven (again) that real-life occurrences can be more severe than conservative projections and assumptions, e.g. for the extent of interest rate change or the outflows of deposits.

This year’s triggers are unlikely to repeat in the near future. But the industry is facing other risks and uncertainties, such as the current geopolitical environment, potential trade wars, impact of USD rate hikes on Emerging Markets as well as the evolving crystallization of environmental risk in banks’ credit books.

Significant risks seem to build up in the property sector with struggling developers in China and parts of Europe; a US office vacancy rate exceeding the GFC levels a maturity wall of more than USD 626 billion for commercial property debt with LTV >80%, due between 2023 and 2025[18]; and credit rating downgrades and dimmer outlook for some small and medium banks.[19]

Last but not least, the interest rate curve (USD) has been inverse since mid-2022, representing short-term rates that have been exceeding long-term rates. Although the term spread seems to be tightening recently, inverse interest rate curves had historically been a comparatively reliable indicator for economic headwinds and sometimes recessions which could translate to additional risks.[20]

The final policy responses and their impacts may still be a few years away. Institutions, including those who weathered the recent events relatively well, should nevertheless learn their lessons from others’ mistakes, strengthen their risk management, and anticipate tighter supervisory and regulatory expectations.

Sebastian L. Sohn is Director with Aurexia, a Paris-headquartered boutique consulting firm with offices in Europe, Asia and the Americas. He leads the group’s Singapore office and assists his clients in the financial industry with the strategic assessment and the practical implementation of regulatory requirements.

[1] BCBS d555 Report on the 2023 banking turmoil, Oct. 2023, https://www.regulationasia.com/bcbs-publishes-stocktake-of-2023-banking-turmoil/
[2] Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, under their individual assumptions of projected appropriate monetary policy, in: Monetary Policy Report – June 2020; https://www.federalreserve.gov/monetarypolicy/2020-06-mpr-part3.htm
[3]BCBS: d555 Report on the 2023 banking turmoil, Oct. 2023; FSB: 2023 Bank Failures: Preliminary lessons learnt for resolution, Oct 2023
[4] HKMA: https://www.reuters.com/business/finance/hong-kong-watch-any-spillover-us-regional-banks-2023-03-24/ ; MAS: https://www.mas.gov.sg/news/media-releases/2023/singapore-banking-system-remains-sound-and-resilient
[5] BCBS: d555 Report on the 2023 banking turmoil, Oct. 2023; FSB: 2023 Bank Failure: Preliminary lessons learnt for resolution, Oct 2023
[6] Speech by Pablo Hernández de Cos, Chair of the Basel Committee on Banking Supervision and Governor of the Bank of Spain at Eurofi Financial Forum, 14 Sep 2023, https://www.bis.org/speeches/sp230914.htm
[7] https://www.snb.ch/en/iabout/pub/oecpub/id/pub_oecpub_stabrep
[8] The write-down of AT1 in Switzerland prompted HKMA and MAS to clarify the treatment of AT1 in their respective jurisdictions: AT1: https://www.hkma.gov.hk/eng/news-and-media/press-releases/2023/03/20230322-3/; https://www.mas.gov.sg/news/media-releases/2023/mas-statement-on-additional-tier-1-instruments-issued-by-singapore-banks; https://www.regulationasia.com/apra-considers-options-for-making-at1-bonds-more-useful/
[9] See https://www.regulationasia.com/bis-paper-suggests-redesign-of-at1-instruments-may-be-warranted/
[10] : https://www.bis.org/press/p231003.htm
[11] https://www.ecb.europa.eu/press/key/date/2023/html/ecb.sp230609~c9ef904931.en.html
[12] see first CR-SA consultation paper in 2014: https://www.bis.org/bcbs/publ/d307.htm)
[13] FSI Insights No. 29 from 16 Dec 2020 https://www.bis.org/fsi/publ/insights29.htm
[14] https://www.fsb.org/2020/10/the-use-of-supervisory-and-regulatory-technology-by-authorities-and-regulated-institutions-market-developments-and-financial-stability-implications/
[15] https://www.regulationasia.com/regulatory-reporting-lessons-from-singapore-and-australia/
[16] https://www.mas.gov.sg/news/parliamentary-replies/2023/written-reply-to-parliamentary-question-on-use-of-artificial-intelligence-in-supervision-of-fis)
[17] https://www.apra.gov.au/review-of-data-collections-roadmap)
[18] https://www.economist.com/finance-and-economics/2023/08/29/high-bond-yields-imperil-americas-financial-stability
[19] https://www.bloomberg.com/news/articles/2023-08-08/moody-s-has-more-gloomy-view-on-us-banks-amid-several-strains
[20] https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/

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