The post-2008 banking reforms are now being tested – and they are failing
After more than a decade of historically low interest rates, the past 18 months have seen them rise rapidly across the world. Firms and individuals inevitably adopted behaviours that worked for them in the period of near-zero rates. However, those same behaviours may be disastrous now rates have risen.
In the UK, many people’s first direct awareness of this came with the problems last autumn for pension funds relying on leveraged liability-driven investment strategies. In the US, we have now seen another very direct case: the collapse of Silicon Valley Bank and Signature Bank. These were the second and third-largest bank failures in US history.
Higher interest rates will inevitably trigger additional financial problems in sectors such as mortgage and commercial lending, and those in turn will lead to financial problems for some banks and other financial institutions. Markets have become nervous and turned on banks that had been regarded for many years, already, as having significant problems. The most high-profile of these is Credit Suisse, one of the nine “bulge bracket” global investment banks and, by the international Financial Stability Board’s definition, a globally systematically significant financial institution. Credit Suisse’s contingent convertible debt (its debt that is pre-earmarked as the first to be converted in the event the bank has solvency problems) has recently been trading at a 60 per cent discount (implying an extremely high probability of default) and its shares have been down more than 97 per cent from their historic peak.
Credit Suisse has been in this condition for some time and survived until now; Swiss regulators say that it is fundamentally sound and the bank is now being taken over by UBS. But regardless of Credit Suisse’s rescue, we are about to seriously test the post-2008 system of banking regulation. We will see whether it has succeeded in its central objective of allowing banks to be unwound, after they collapse, without government support but also without destabilising otherwise-healthy firms and markets.
The early signs are not promising. European regulators are furious with the US authorities over their handling of the recent bank collapses. One of the most important objectives, post-2008, was to create regulatory and policy systems that removed the obligation which the authorities felt, in 2008, to ensure no depositor lost money.
Banks have deposit insurance, with only depositors holding balances up to certain thresholds (£85,000 in the UK or $250,000 in the US) being guaranteed. Depositors with very large balances were supposed to be treated as investors who could reasonably be expected to assess to whom they loaned money – and a deposit in a fractional reserve bank is a loan. It is lent for the bank to use in various ways, and the bank pays the depositor interest in return.
But the US authorities have guaranteed all of the deposits of US depositors, without limit, not respecting their formal $250,000 cap. European authorities are furious about this, as it flies in the face of more than a decade of nuanced regulatory discussions and public undertakings not to bail out large depositors.
I understand the European position, but I feel they are naïve – indeed, their whole regulatory framework is naïve. It absolutely should be the case that depositors are not insured without limit. Indeed, there should be no deposit insurance whatsoever – as we used to have in the UK prior to 1979 (it was only imposed via an EU Directive).
Deposit insurance is a cancer at the heart of the capitalist system, destroying its ethical foundations. Rich depositors should not be able to secure returns, in the good times, for investing in fundamentally risk-bearing activities (which fractional reserve deposits are, by their nature) but then be bailed out by the government when times are tougher. And banks are the largest allocators of capital in the economy – so this fundamental injustice gets spread across the entire economic system.
Yet, as the US authorities have just shown, mere political will is not enough. No politician wants to be De La Rua, the Argentine president forced in 2001 to flee the presidential palace in a helicopter to escape from a mob of unhappy depositors that had caused the deaths of 22 people. To make it credible not to bail out depositors, the public needs to feel that depositors had an alternative.
The way that should have been done was by mandating that all banks licensed to receive deposits should offer 100 per cent-backed, legally separated “storage” deposits, of the form that used to be available in “savings banks” until the 1970s (some readers will remember the trustee savings banks), offering near-zero returns for total safety. To deposit in a fractional reserve bank, one should have to turn down depositing in a storage deposit account. That way, everyone would know that all fractional reserve depositors had chosen to take a risk to get higher interest returns, so can have no excuse for demanding government assistance.
The best time to have done this was after 2008. It should be done as soon as possible. Our current financial system still embeds the economic and ethical cancer of deposit insurance. We need to escape, and escape soon. With permanently higher interest rates, the clock is ticking louder every day.