When banks go bust there are four factors at play

Banks are in the news again. Two bank failures in the US, and the forced takeover of Credit Suisse by UBS in Switzerland, have triggered the worst turmoil in the banking sector since the 2008 financial crisis. There’s talk of a lack of trust, of a collapse in confidence, of contagion and systemic risk. Jannie Rossouw explains why they’re concepts worth understanding.

Trust

The whole principle of banking is built on trust. Clients deposit money with banks to receive interest and trust that their deposits will be repaid at maturity. Banks lend money to borrowers, trusting that lenders will pay the interest on borrowed funds and will repay the borrowed capital in accordance with the loan agreements.

Staff members work at banks, trusting the institution’s ability to pay salaries and provide other agreed benefits. Bank supervisors trust that their models and control mechanisms will raise warnings about liquidity, solvency and other risks facing any bank in a timely fashion. This will allow them sufficient time to step in, for instance by appointing a curator for a bank about to get into trouble.

In South Africa, the South African Reserve Bank is responsible for bank supervision. Stakeholders trust that it will do its job and keep their money safe. They trust that the individuals managing the banks will do so in a proper and sound way, thus not putting the economy or the banking system at risk.

Lastly, shareholders in a bank provide permanent capital for the institution, based on the trust that their investment will grow in value and pay them dividends over time.

Confidence

All this confidence rests on the ability of banking institutions to manage risks appropriately. The very basis on which banks operate is risky. Banks are exposed to various types of risks that can contribute to failure. This is where confidence is important.

Banks are in the business of taking short-term deposits and converting those into long-term borrowing. Loan duration is longer than deposit (also called funding) duration. Therefore, if all depositors are spooked, and lose confidence in the bank’s ability to keep their money safe, they might start demanding repayment of their deposits on the same day. A bank can simply not meet such a demand for simultaneous withdrawals.

Another major potential hurdle is liquidity risk. Liquidity risk emerges when depositors want their deposits back and the bank can’t repay them all at once. It can trigger other problems.

Liquidity risk can also emerge when the assets of banks drop in value. The assets of a bank are the loans made to the public. Defaults on the repayment of such loans require write-offs. This erosion of asset value can trigger liquidity and solvency risks.

Silicon Valley Bank in the US invested heavily in government bonds. When bond rates increased, the capital value of the bonds held by the bank declined. This resulted in a liquidity shortage and a solvency crisis.

Once sufficient risks are triggered, a bank will run into serious financial difficulty. It might not survive, because trust will be shattered.

Under such circumstances, the authorities appoint a curator to manage the bank’s affairs. A curator will either manage a bank back to sound health, or will wind down its business and bring the bank to a closure.

In recent years in South Africa, VBS Bank and African Bank were placed under the control of curators. VBS Bank was completely insolvent and therefore closed. Many depositors suffered large losses.

In the case of African Bank, the curator could split the assets into a “good bank” (performing assets) and a “bad bank” (non-performing assets). These two parts were managed differently, with the good bank and performing assets moved back into private management as African Bank. The non-performing assets were kept apart and managed with the aim of recovering as much as possible from lenders.

Contagion

Contagion happens when a lack of trust in one banking institution spreads to others. This happened in 2008, when so-called sub-prime mortgage bonds were repriced with higher interest rates and borrowers could not afford larger repayments. Problems at some banks resulted in distrust in the whole banking industry.

In the past two weeks, there was again a risk of contagion after problems emerged at Silicon Valley Bank and at Credit Suisse in Switzerland. In both instances, the regulators stepped in to contain fears about the banking system. It was agreed that Credit Suisse would be sold to UBS, another Swiss bank. The announcement of this sale contained fears of contagion.

Contagion can spread beyond the banking system. Financial contagion refers to the spread of an economic crisis from one market (for instance the banking sector) or one country to other markets (for instance the insurance industry) or other countries.

Under these conditions, confidence in industries or even in countries can dissipate overnight. This is what happened in 2008, when there was doubt about the continued existence of the international banking system. Under such conditions, people revert to cash and keep their savings in banknotes. This in itself places a liquidity squeeze on the banking system, as cash flows out of the system.

Systemic risk?

Systemic risk is linked to contagion. It’s the risk of a breakdown of an entire system rather than the failure of an individual institution. A typical example is where the failure of individual banks results in the failure of more banks, then the failure of the banking system and then the failure of the entire financial system.

Systemic failure can occur because different financial institutions hold exposures against one another. If bank A has a substantial deposit with bank B or insurer C and any one of the latter two runs into financial difficulty, the result can be that bank A also faces financial difficulty.

Confidence in banking is hard-earned and easily shocked. This makes individual banks and the banking sector susceptible to knock-on effects from other institutions.

What can be done to manage these factors?

Risks in banks are managed at two levels.

The management of the bank is responsible for its sound operation. Management must assess and mitigate risk. In the recent case of SVB in the US, reports suggest that the bank didn’t manage its risk portfolio well, putting it at risk from major changes in the market, like sustained higher interest rates.

At the same time, banks are subject to supervision by the authorities. Banks must meet the regulatory requirements of supervisors and manage their affairs accordingly.

In South Africa, legislation makes provision for different types of banks to allow for different levels of sophistication in banking operations.

How vulnerable are banks on the African continent?

Africa is a vast continent of 54 countries. African countries are also at vastly different levels of economic development. It is therefore impossible to pronounce on the soundness of the continent’s banking system.

Jannie Rossouw, Visiting Professor at the Business School, University of the Witwatersrand

This article is republished from The Conversation under a Creative Commons license. Read the original article.