Global banking is now in Schrödinger’s box

The writer is a contributing editor of the FT

The famous quantum mechanical thought experiment states that if a cat is sealed in a box with a lethal substance, you won’t know if it’s alive until you open the box. Meanwhile, he lives and dies at the same time. It is the same in the banking sector today: we cannot know whether the past week was a series of unique, manageable problems or the beginning of a 2008-style banking crisis. Currently both.

Investors and depositors must not only believe that banks have good capital ratios, have ample access to liquidity and behave responsibly, but also that the supervisory and regulatory architecture introduced after 2008 to save the system is working. In the short term, trust can be gradual in all of this. But when we finally look inside the box, investors have to either trust these things or none of them. It’s a binary result: the cat can’t be a bit dead.

The reason points to the fact that the recent banking instability presents a number of manageable problems, mostly based on supervisory and governance issues. Silicon Valley Bank, Silvergate Bank, and Signature Bank were unusually exposed to interest rate risk through both their customer base (which itself is a phenomenon of the low interest rate environment) and their assets (long-term bonds that had to be sold at huge losses to redeem them). deposits). First Republic’s rich depositor base, which is largely uninsured, has also been caught up in liquidity concerns. Credit Suisse, which has been in trouble for a number of reasons in the past, is now dealing with trust and liquidity concerns.

The good news is that a lot has changed since 2008. The capitalization and regulation of banks is much better than before the global financial crisis. And as terrible as this period was, we learned many lessons from it, including the importance of quick, decisive action in containing the infection.

Central banks immediately dusted off the liquidity crisis management playbook and stepped in as lenders of last resort. The US Federal Reserve, Treasury and FDIC guaranteed all deposits for SVB and Signature Bank, and the Fed created a new lending program, the Bank Term Funding Program, for banks with underwater securities. The Swiss National Bank has extended a credit line of up to SFr50 billion ($54 billion) to Credit Suisse.

The bad news is that confidence in the banking sector has not yet been restored. A week after the U.S. programs were announced, First Republic remains under pressure — even after receiving $30 billion in deposits from major banks. Its shares fell 33 percent on Friday. All banks a KRE banking ETF they were below; the index closed at 6 percent. Fed data showed it borrowed $11.9 billion through its new facility and a record $152.9 billion through the usually stigmatized discount window in the week to last Thursday. Clearly, liquidity is a concern throughout the US system. Despite the new credit line, Credit Suisse and its rival UBS AG spent the weekend in acquisition talks.

Central banks and regulators must do more to restore confidence. Basic confidence in the banking system is shaky. And I fear that even more toxic substances may end up in Schrödinger’s box. Commercial real estate loans account for about 28 percent of loans at small banks in the U.S. (compared to 8 percent at the largest banks). Some of these are underwater due to high interest rates and the shift to working from home due to the pandemic. If even a few small banks have to write down their assets, solvency issues become sticky.

Another risk lies in the private markets. They don’t have to mark to market and have posted much smaller paper losses over the past year than the public markets. They can postpone the crystallization of losses in the hope that the value of the assets will reorganize in the meantime. However, if assets continue to decline, the losses could be staggering. Private markets can undermine financial stability.

We shouldn’t assume the cat is dead and a banking crisis is upon us, but we will continue to experience market turmoil as central banks continue to extract liquidity by raising interest rates and shrinking balance sheets. After the financial crisis and the Eurozone crisis, this is the third time in two decades that we have banking problems. More needs to be done to rebuild and maintain trust in the system. Even if the cat is alive this time, we can’t assume it has nine lives.