March 2023 saw the global banking sector experience its most significant bout of turmoil since the 2008/9 financial crisis. The failures of Silicon Valley Bank and Signature Bank in the US, and vulnerabilities in other mid-sized banks, were met with swift and robust action from authorities. Nonetheless, the knock-on impact on investor sentiment exacerbated concerns over Credit Suisse, leading to its forced and not uncontroversial merger with long-time competitor UBS.
A full-blown banking crisis, akin to that seen in 2008/9, is unlikely, thanks to evolutions in financial regulation that have led banks to be much better capitalised. Credit conditions will likely be tighter, however, which will have a modest negative impact on global economic activity. Meanwhile, these developments seem likely to have implications for the future direction of financial regulation globally.
What you need to know
What's triggered the crisis?
On 10 March, the closure of Silicon Valley Bank (SVB) by the Federal Deposit Insurance Corporation (FDIC) and the associated guarantee of all deposits created shockwaves across the US financial system. A mid-sized bank with close links to the US tech industry, SVB had fallen victim to a run by depositors due to concerns that it was unable to cover its uninsured deposits - with $42bn withdrawn in a single day. Just a couple of days later, the FDIC shut down another financial institution - Signature Bank - which had also experienced a similar run.
The collapses of SVB and Signature Bank were mostly driven by mismanagement of assets. In the case of SVB, they had invested heavily in US Treasury bonds, which have declined in value as interest rates have risen. This resulted in a mismatch between the bank’s assets and its liabilities. Signature Bank had a similar problem to SVB, but, instead of Treasuries, it had a heavy exposure to crypto assets (which have also fallen in value recently). It’s also worth noting that, as mid-sized banks, both SVB and Signature Bank were not subject to the stricter liquidity rules faced by larger US financial institutions that may have averted the crisis in the first place.
These bank failures raised concerns that other financial institutions - such as First Republic Bank - could be at risk of similar runs. In response, the US Federal Reserve opened up the Bank Term Funding Program (BTFP), a new facility to provide temporary liquidity to banks under pressure. First Republic was also supported by 11 large banks in the US, who deposited $30bn, with US Treasury Secretary Janet Yellen assuring banks that the authorities are prepared to guarantee further deposits if necessary, conditions have stabilised somewhat.
Nevertheless, there remains a sense of nervousness that other small or mid-sized US banks may come under pressure in the future.
Has there been any spillover to larger, more systemic banks?
Across the Atlantic, the major victim has been Credit Suisse. The Swiss bank had been struggling for a number of years, and recently posted its biggest annual loss since 2008. However, Credit Suisse was ultimately felled by the decision of its biggest financial backer, Saudi National Bank, to refuse to invest more money in the bank.
The loss in confidence triggered a collapse in Credit Suisse’s share price and a bank run that, ultimately, saw the 167-year-old bank being (forcibly) bought out by its long-time competitor, UBS. Although the merger has prevented a broader fallout (for the moment), the structure of the deal caused its own problems.
Significantly, Swiss authorities decided to impose a loss of $17bn on certain bond holders. Meanwhile, the bank’s shareholders still received a payout from UBS, overturning established assumptions that debtholders would be prioritised over equity holders in the event of a bank failure. This will likely result in various legal cases, and has already led to volatility in the bond market. In an attempt to shore up confidence, the Bank of England and European Central Bank have confirmed that similar bondholders would take priority over equity holders in UK and European banks.
Credit Suisse’s problems were largely idiosyncratic and related to poor management, but it presents an example of how a more systemic financial institution can fall victim to the jittery sentiment caused by the bank failures in the US. Scrutiny of larger banks across the globe certainly seems to have intensified: Deutsche Bank’s shares fell sharply on 24 March, as the cost of insuring against its five-year debt rose. However, authorities have given reassurances that Deutsche Bank is profitable and stable.
What's happened in the UK?
The impact on the UK has been relatively small compared to the experiences of the US and Switzerland. Following the collapse of SVB in the US, the UK government and Bank of England acted quickly to find a buyer for the UK subsidiary of the embattled bank. HSBC ultimately acquired SVB UK (for a symbolic £1), thus preventing any immediate spillovers from the US to the domestic UK banking system.
More broadly, the UK banking sector seems to be well prepared to face the types of banking stresses that have threatened banks in other countries. Strong capitalisation rules following the 2008/9 financial crisis mean that the UK banking system should be more resilient to a period of high interest rates. Furthermore, certain UK commercial and retail banking operations are ring-fenced from their international and investment operations, which helps protect them from the kinds of vulnerabilities that affected SVB and Signature Bank.
Finally, the Bank of England has demonstrated in the past that it is prepared to act with scale and speed to support liquidity in the banking system: for example, the £250bn in funding it provided following the Brexit referendum vote in 2016. Taken together, these sorts of measures should reassure investors, and help prevent the sort of banking stresses that we’ve recently seen elsewhere from happening in the UK.
Are we headed for another global financial crisis?
While it's difficult to predict how banking crises may play out, as things stand, it doesn't seem like the world is facing a similar situation to the 2008/9 crash.
Firstly, strong capitalisation and liquidity rules put in place following the financial crisis mean that banks in the UK and other developed economies are now in healthier positions. Secondly, governments and central banks have learnt to act quickly and decisively to support the banking system during these sorts of crises, using a number of tools to combat liquidity risks that they didn’t have in 2008.
Nonetheless, it’s possible that vulnerabilities could be lurking in the global banking system, particularly in smaller or regional US banks, which are subject to less stringent regulation. Should interest rates rise materially further, over-leveraged sectors and investment funds may come under pressure.
At present, the main source of contagion to the real economy is likely to be a tightening in financial conditions which will weigh on economic activity. For the UK, early estimates from Goldman Sachs suggest a modest drag on activity, shaving 0.2% off the expected level of GDP in the near-term (compared with 0.3% in the Eurozone). The US is also expected to see slightly slower activity this year, with Goldman lowering their 2023 Q4/Q4 GDP growth forecast by 0.3pp (to 1.2%). It is important to note, though, that forecasters are not expecting the current banking stress to result in a full-blown recession of the scale of the 2008/9 financial crisis (when UK GDP fell by 6%).
What’s next for interest rates in the UK?
Given the role of higher interest rates in the recent banking turmoil, financial markets had been speculating that central banks might choose to cut rates from their current level to shore up financial stability. However, so far central banks have remained undeterred in pursuing monetary tightening. The Bank of England raised rates to 4.25% (a 0.25% increase) on 22 March, following decisions by the European Central Bank and US Federal Reserve to also press ahead with interest rate hikes, of 0.5% and 0.25% respectively.
One of the key differences between the financial crisis in 2008/9 and now is that the world is facing far higher rates of inflation. In the UK specifically, CPI inflation has averaged 9.2% since January 2022, compared with 2.3% from 2005-07. Central banks may have considered cutting interest rates to maintain financial stability in a pre-2008/9 world, but they have built up a number of additional policy tools in the past 15 years to be able to support the financial system without having to abandon rate hikes as their primary lever to bring down inflation.
The Bank of England’s decision to continue tightening monetary policy reflected headline inflation outpacing the Bank’s forecast, and near-term economic activity improving in the UK and globally. Nevertheless, its Monetary Policy Committee (MPC) observed that bank wholesale funding costs rose in the wake of SVB’s collapse and UBS’s purchase of Credit Suisse, which could affect the credit conditions faced by UK households and businesses.
Going forward, we are of the view that central banks - especially in the US and the UK - are at, or close to, the peak in their monetary tightening cycles, which should reassure markets and investors. Inflation is set to fall significantly this year off the back of falling energy prices, and the additional tightening in financial conditions will also have a disinflationary effect on the economy. However, with the UK labour market remaining tight, we expect that the MPC is likely to maintain interest rates at their current level into 2024.
What are the implications for financial regulation?
Recent developments have inevitably called for tighter regulation of the banking and broader financial sector. A partial reversal of the Dodd-Frank Act in the US, which exempted some smaller banks from the toughest supervisory measures, is widely cited as a factor behind why the issues at SVB were missed. It’s possible that things may have also fallen between the cracks in the US’ dual federal and state oversight system.
However, the implications for financial regulation more broadly at this stage are unclear. There are questions around the future scope of deposit coverage insurance in the US. Other near-term concerns centre around the role of government bonds in banks’ risk portfolios (particularly large uninsured exposures, in the case of SVB), and the future role of AT1 convertible bonds (notwithstanding recent reassurance from the Bank of England and ECB).
In the medium-term, it’s possible that we will see financial regulation tightened across the globe. For example, the US may consider changes to its capital rules for small to mid-sized banks to avoid another SVB-style collapse. In the UK, the government has reiterated its intention to deliver its Edinburgh Reforms, but regulators may look more warily towards any plans that could open up risks for the domestic banking system.
What do recent events in global financial markets mean for UK businesses?
Tighter financial conditions are expected to have a tangible impact on businesses across the UK this year. Our business surveys indicate that the cost of finance was already becoming a more widespread concern among UK businesses as interest rates have risen, and the latest events in the global banking sector may further impact credit costs, and possibly availability, for UK businesses. We will continue to engage with CBI members regarding the cost and availability of credit and its impacts in the coming months.
It is possible that other financial institutions and instruments across the globe may come under pressure as the impact of higher interest rates continue to bed in. While the UK banking sector is judged to be resilient, the experience with liability driven investments in the autumn and the most recent banking sector volatility shows that vulnerabilities can be revealed in unexpected places. Nonetheless, the prompt and coordinated actions of global monetary policymakers and national authorities should give comfort that the hard-learnt lessons of the global financial crisis, the European sovereign debt crisis, Brexit, and the pandemic have honed the tools needed to deal with more large-scale market turbulence.
