How we can avoid a third phase of banking turmoil

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

The US banking tremors are evolving. The first phase of the turmoil, when sudden and massive deposit outflows from poorly-managed and inadequately-supervised banks caused spectacular failures, has been stabilised.

The current phase, which focuses on funding cost and balance sheet issues of less problematic banks that happen to operate in a highly unsettled neighbourhood, can also be stabilised. Indeed, it must if we are to avoid a third phase entailing considerably more financial and economic damage.

Let’s start with the good news. We are unlikely to see the sort of dramatic institutional collapse experienced by Silicon Valley Bank during which $42bn of deposits flew out in one day and another $100bn was projected to follow out the door the next day had regulators not shut down the bank.

This good news is due to two main factors. First, through practice rather than through legal change, the authorities have signalled that the $250,000 ceiling on the state guarantee of individual deposits has been replaced by unlimited coverage. The trick is simple. The Federal Reserve just declares a systemic risk exception. Second, the Fed opened a funding window that allows banks for one year to exchange at par securities that are worth significantly less in the marketplace. This reduces the risk of banks having to sell at a loss to meet deposit outflows and provides them with subsidised funding.

This important stabilisation has been far from perfect as it only addressed part of the banking system stress while inflicting collateral damage and unintended consequences. Quite a few US regional banks still operate with mismatches between their short-term liabilities and longer-term assets. Their balance sheets are further encumbered by dodgy commercial real estate loans.

Moreover, they are subject to a regulatory regime that has not ensured adequate capital coverage — a lapse that is amplified by the patchy supervision that was detailed in the Fed’s own assessment of SVB’s failure. They also remain vulnerable to the Fed’s mishandled interest rate hiking cycle. And all this is likely to damp the banking system’s enthusiasm to extend credit even if moral hazard is greater.

Fortunately, these banks do not have as many immediate structural weaknesses as those which failed. Consider, as an example, PacWest, which found itself on the ropes last week as its share price plummeted. Its 25 per cent of uninsured deposits pales in comparison with what SVB and First Republic had. Also, its clients base is substantially more diversified. It will, however, have to resolve balance sheet issues and navigate higher funding costs at a time of very jittery markets.

The market mood is not surprising. So far this year, banks with more than $530bn in assets have failed, already exceeding the 2008 total during the global financial crisis after adjusting for inflation. The manner in which First Republic failed is also playing a role. The theoretical alignment of incentives among the main actors proved insufficient to ensure a timely resolution.

Shareholders saw their holdings lose over 95 per cent of their value before the bank was acquired by JPMorgan. Markets now readily punish the stocks of banks, especially those that talk about weighing “strategic options”. This leaves the door open to vicious cycles.

This second phase can also be contained. First, banks must exercise more care in what they say and, generally, have very responsive communication with investors — a lesson already internalised by a few institutions. Second, the Fed must strengthen its supervision regime. Third, public-private resolutions for banks need to be made to work to a tighter timeline if needed. Fourth, the public sector needs to assure markets that, rather than the ad hoc approaches that have dominated so far, it will work to revamp both the deposit insurance system and the regulation of banks erroneously deemed to involve no systemic threat.

Doing so is necessary if the US is to avoid a third, and significantly more damaging, phase of the banking turmoil. Should less problematic banks fail in the next few weeks, the impact on the financial system and the economy would be a lot more consequential.

Notwithstanding an impressively resilient labour market, the US would soon find itself tipped into an otherwise avoidable recession with limited fiscal and monetary policy options. The likelihood of further policy mistakes would be material. And all this just as the slower-moving stress in the non-bank financial sector becomes more evident.