The Future of Banking

Common Threads in Financial Crises

Itay Goldstein: In March of 2023, we had an unusual string of events in the global banking arena. Failures of institutions here in the United States — Silicon Valley Bank, Signature Bank of New York, and First Republic Bank. And the turmoil in Credit Suisse over in Europe. This was the biggest episode altogether since the Global Financial Crisis (GFC) of 2008, and it had a ripple effect on financial markets worldwide, financial institutions, and the global economy, with quick intervention from regulators in Europe and in the United States.

Looking now at the future of banking, we are looking into a new era with some new lessons that have been learned and some new policies that will be in place. I’m here with Hyun and Loretta to dive into these topics and learn some more, and talk about what we can expect going forward.

Let me get started by thinking about what happened in March of 2023. What were the causes of these events? Is there any common unifying theme? Is there any connection to the policies that were in place in the aftermath of the 2008 financial crisis? Hyun, why don’t you get started?

Hyun Song Shin: Yes, Itay, Those are very good questions, and we can certainly learn lessons from what happened in the spring of 2023. In some ways, there are some classical lessons from the events both in the U.S. and in Europe, but in very important respects, the banking stress last spring was very unlike what we saw during the GFC.

The GFC was a major systemic banking crisis when many [highly] leveraged institutions were under stress on the funding side. The theme was very much on the wholesale funding of these large banks, and you may recall all the discussions about shadow banking, special purpose vehicles and so on.

It’s important to bear in mind the macro backdrop. We had this burst of inflation in 2021, and so central banks raised rates in 2022.What that meant was that some of the securities holdings of banks lost value in a marked-to-market sense. But many of these securities were held on an ultra maturity basis, which meant that the losses needn’t be recognized as they lose value.

In the case of SVB (Silicon Valley Bank), for example, there was already a very large increase in deposits, which were then put into these securities. But when you have a run, you do need to sell the assets, and that’s when the losses would be realized. So, that was a particular feature of the macro environment at that time, but it wasn’t a systemic crisis in the same way that the 2008 Global Financial Crisis was.

The story with Credit Suisse was somewhat different still, because this was a major, globally systemic banking institution. It wasn’t a retail institution in the same way that some of the smaller banks were in the U.S. But what it saw was after a series of mishaps in its business, the stresses that were happening at that time meant that its wholesale creditors were similarly withdrawing their funding. And so, it was a slightly different episode, but it shares the same kinds of commonalities in the sense that it was a liability-side driven event that interacted with the asset side. That would be one way of putting it.

Goldstein: Thank you. And Loretta, some reflections from you?

The Vulnerabilities of Uninsured Deposits

Loretta Mester: Fundamentally, there were two key factors for SVB, and they were just doing very poor interest rate risk management. As Hyun said, the bank had tripled in size in a very short period of time in terms of its assets, and it was funding those securities with a very high proportion of uninsured deposits. Over 90% of its short term funding was uninsured deposits. So they were very vulnerable, and they weren’t really managing that risk.

In fact, they leaned into that risk, because they moved securities into the [specific] maturity buckets on their balance sheet so they wouldn’t have to mark them to market. They were also vulnerable in another way, in the sense that they had a very concentrated depositor base. So, a majority of their deposits came from firms that were in tech and venture capital. Of course, when venture capital [firms] got under, their activity started declining as interest rates increased. They found themselves in trouble, and they really weren’t managing that risk at all.

But there was a second factor. We know banks are set up to lend long and borrow short, and so they are subject to interest rate risk, and it’s up to them to manage the risk. We also have bank supervision, and supervisors are supposed to make sure that banks are managing their risks in a safe and sound manner so that they can continue to lend and serve their important roles for their customers. In this case, bank supervision also was very weak.

The Fed was responsible for much of this. The Fed didn’t really understand the vulnerabilities of SVB, especially as the institution grew in size. Once the vulnerabilities were fully appreciated, the supervisors didn’t act quickly enough and forcefully enough to get the SVB management to fix the problems they were having. So, it would be a combination of both poor interest rate management and risk management on the part of SVB.

Combined with [all that was] weak bank supervision, and that really wasn’t done with speed and agility in a changing interest rate environment. So, when interest rates began rising and they rose aggressively, it revealed the vulnerabilities in that bank. Depositors woke up and said, “Oh, we have some concerns here.” They were alerted to this fact because SVB tried to do a capital raise and had to sell assets to do that, and so they had to take those losses.

Then depositors started to run, and while it wasn’t a systemic event at the moment, it did cause runs at other banks, such as First Republic and Signature Bank. There was concern that it would become a systemic event, and many large regional banks suffered in terms of depositors running. This may be indicative of [the fact that] we have not solved the too-big-to-fail [issue]. The deposits ran into very large banks, because the depositors believe that those banks would not be allowed to fail. So we have not solved that problem.

Coming out of the financial crisis, there were a lot of reforms done. The Dodd-Frank [Wall Street Reform and Consumer Protection Act of 2010] was to try to address the too-big-to-fail problem. This episode shows that that has not been adequately addressed. So, I agree with Hyun that there’s there are lessons here, certainly [with respect to how] the regulators and the Federal Reserve do supervision and also regulatory changes. But here, I put more of the burden on the supervisory part of it, not the regulations themselves.

Takeaways for Monetary Policy Formulation

Goldstein: You both mentioned the connection to monetary policy, and Loretta, you said that there are lessons now going forward for supervision and regulation. But another question is, what are the lessons going forward for the way that the Fed is conducting monetary policy, to the extent that you can say something about that?

Mester: Remember, this all happened in early March [2023], and there was an FOMC (Federal Open Market Committee) meeting on March 22 of that year. At that meeting, the Fed persevered [with] its interest rate increase, so it did another increase of 25 basis points. We didn’t allow the stresses in the banking system, per se, to deter from what needed to be done from a monetary policy point of view, given where inflation was. Inflation at the time was running above 5%, and it was clearly well above the goal of 2%, and unemployment was very low at the time.

So, of course, the obvious thing to do with your monetary policy is to tighten interest rates again. There was certainly a lot of focus on whether those stresses would become wider spread, and there was concern. If you recall, when SVB failed, the Fed also had to set up an emergency lending facility, the Bank Term Funding program, which allowed banks the faced liquidity issues to put the securities they were holding on their balance sheets at face value; they could actually put them at the Fed at fair value and borrow against them so they wouldn’t have to sell them.

That program, combined with what the Treasury and FDIC (Federal Deposit Insurance Corporation) did for some of the banks, basically said, “We’re going to make sure that all deposits are insured,” that quelled the stresses. The FOMC felt that there was risk out there of continuing on its campaign of raising interest rates, but it was the right thing to do from a monetary policy point of view. And then we’d have to very, very be attuned to those risks.

You need a healthy banking system for two reasons. One, you want monetary policy, whatever you take on the policy front, to transmit through the broader economy when the financial markets aren’t working. When they’re disrupted, monetary policy won’t transmit. But also, we wanted the banks to remain healthy and not pull back on all the credit extension, because they were actually helping to support the economy as well.

There was a lot of discussion about continuing to monitor [the prevailing situation], but [also] to persevere and put another interest rate increase in. [The Fed] likes to use regulation, supervision and macro prudential [policies] to the extent we have it in the U.S., to focus on financial stability and then have its monetary policy tools, interest rate increases, or asset purchases, and balance sheet policies really focused on the macro policy goals of full employment and price stability.

So, we were able to do that, but there was a lot of attention paid to [concerns that] we are taking some risk here, and you’d have to make an evaluation of whether you thought we could continue on that. And we were looking at that. The broader question, Itay, and maybe this is one that you were alluding to, was we were raising interest rates very quickly — unprecedented quickness in how we were having to raise interest rates. We had to do that, given where inflation was.

But no one felt that we would have preferred not to have to do that, let’s put it that way. Monetary policy was so out of position for where it needed to be, given what was going on in the macro economy, that we had to do that. So, I think one of the lessons is, don’t let your monetary policy get out of position. Always maintain it in a good position, which means always being attuned to the risk — upside risk, downside risks, inflation risks, and unemployment risk, so that you aren’t in a position where you feel you have to really move quickly and with large increases or decreases, which can be hard for financial markets and institutions to handle.

Pointers for International Coordination

Goldstein: Yes, that’s a very important lesson. Hyun, you sit in the Bank for International Settlements, and you think a lot about international coordination of financial regulation and supervision, and what happens with cross border transactions and international banks. To some extent what happened in March of 2023, a lot of it was concentrated in the U.S., but then we saw how the panic and sentiment spread over and affected Credit Suisse in Switzerland, even though the fundamentals and the situation there was very different. What do you think are the lessons going forward for coordination at the international level?

Shin: Of course regulation is going to be a very important building block in in any kind of financial stability framework. But let me just underline one thing that Loretta said, which I think is very, very important, which is that [along with] the regulation, supervision itself is going to be really the key.

What the events of last year showed was how important it is to get the basics of supervision right. So, the way you should think about the difference between regulation and supervision is regulations are the hard rules — the ratios, particular numbers, capital, liquidity, and so on. But the supervision really has to do with the business model. How coherent is it? How good is the risk management?

And as Loretta explained very well it was those business-model issues, the risk management issues, which really came to the fore. So, before we even go to regulation, we have to emphasize how important supervision is, and that’s done at the national level. It’s the national supervisors who are in the driving seat. Now, with the regulation, what will be important for the international forums like the Basel Committee would be when competition also becomes part of the discussion.

The very first Basel Capital Accord back in 1988 came about because of the consensus among all the supervisors that there needed to be a way to make sure that the internationally active banks who compete in various markets globally are competing on a level playing field. So no one jurisdiction is deviating very much from others in [a way] that one bank somehow has an advantage competitively.

So, it’s a way to prevent this race to the bottom — or a potential race to the bottom — where, if the competition is unfair, then some banks may be at a greater advantage relative to other banks. That’s really the role of the international coordination. This has been a very important piece in this international discussion. But it’s very important to emphasize that it is the national supervisors who are in the driving seat. Whatever is discussed in the Basel Committee doesn’t have the same legal force as something like an international treaty.

It’s very much a discussion shop, and whatever is discussed is then implemented by the national authorities. To that extent, the lessons that we learned in March of last year are being actively discussed [along with ways of] strengthening at the level of national regulation.

Liquidity, clearly, is a very important part of this, and this is still very much in process at the moment. But the role of international discussions has to be to put in this broader context. There is a fairly limited role there in terms of coming up with specific recommendations, but it’s very much a part of the consensus-building among the national supervisors.

Time to Revisit Deposit Insurance?

Goldstein: A different aspect of government intervention and government involvement, I would say, is deposit insurance. For many years, this was a very important part of addressing financial fragility and preventing crisis. We saw that deposit insurance was updated in the U.S. in 2008 following the beginning of the Global Financial Crisis. Since then, it hasn’t been updated. But then in March of 2023, after the run on SVB and the beginning of runs in other banks, there was this shift to implying that everyone will be guaranteed, whether they are insured or not. And now there are discussions that maybe the policy should be updated, maybe there shouldn’t be a limit, and maybe there should be some distinction on the limit on different kinds of deposits and different kind of accounts. Where do you think this is going?

Mester: Well, Itay, you’re right, there are a lot of proposals out there. You want to have market discipline, working with bank supervision, and bank regulatory rules, including deposit insurance. I’m not sure — the first place I would go wouldn’t necessarily be to just have a blanket increase in the cap on deposit insurance, which is $250,000 per depositor at this point. But there are things that are probably worth considering.

One thing is, is it smaller now than when it was set in 2008, because the economy has gotten bigger? There are people who think that you should adjust that, just on that ground. But I also think you want to think a little more thoughtfully about what would be the trade-off there, because someone has to pay for that higher level of deposit insurance. Right now, the banks pay fees, but if they’re paying that, and they’re covering that, then of course, they wouldn’t be able to lend as much. So you have to think about whether that’s the right approach.

One thing that became clear in this SVB situation was that a lot of their customers and firms, and even those of other regional banks, were really concerned that they wouldn’t be able to pay their customers and, workers. So, there is an idea that you could distinguish business accounts and transactions accounts, from other kinds of deposits and have a special account and special deposit insurance for those, because those are really important for the functioning of the economy. But the whole idea of these is to try to make sure that depositors don’t feel that they’re in a situation that they have to run to be the first to take their money out of the bank.

Destigmatizing the Discount Window Option

The other approach, aside from deposit insurance, for the U.S. in particular, is have a discount window. The discount window is where the Federal Reserve, as a central bank, lends to healthy firms when they have temporary liquidity problems, as long as it’s backed with good collateral.

In the case of the stresses in March 2023, it became very clear that the regional banks — not the ones that were on the way to failure, but the ones that were finding that it was hard to fund in the environment that we were in with the stress — were very reluctant to come to the discount window. They didn’t really feel that they could without stigmatizing themselves. In other countries, their lending is not as stigmatized — in some of those countries it’s not at all — compared to the U.S.

There’s work going on at the Federal Reserve to try to make the discount window much more attractive in terms of making sure that banks know and are well positioned to be able to use it. So, for example, the legal documents and agreements have to be in place. There’s a big campaign to make sure that firms, the banks, and institutions that are eligible to borrow at the discount window, have those already in place, that they have collateral already evaluated, so that they can borrow much more quickly than was the case during the stresses of March 2023.

That has been very worthwhile. [As for] the number of institutions — banks as well as credit unions who are eligible to borrow — is probably around 8,000. I think well over 5,000 institutions have those legal documents in place now. So, there’s been work to try to do that. But ultimately, it’s still a bit stigmatized. Even if banks are able to borrow, will they borrow?

So, there’s work going on to try to maybe give it a carrot as well as a stick. So for example, include discount window contingent funding as part of the liquidity plans that banks have to submit as part of showing that they’re doing safe and sound liquidity management. Or making sure that barring the discount window doesn’t count against the bank in terms of their supervisory treatment.

So there’s work going on to try to de-stigmatize the discount window and make it part of the plan for contingent funding that institutions have. That’s very promising, and that may be as promising as any kind of reform of deposit insurance.

Goldstein: Hyun, did you want to add to that?

Shin: Yes, let me add that — as Loretta laid out very well — we have to think about the deposit insurance discussion within the broader context of liquidity risk for the bank, and how you would manage that liquidity risk. Simply focusing on deposits would not address, for example, some of the issues that banks faced during the GFC, when the problem was the wholesale funding market, and the run, if you like, on some of those banks were happening because some of the wholesale creditors were shrinking their exposure for their own risk management reasons.

It’s more prudent behavior and more prudent lending on the part of the party that’s shrinking that funding, but it looks like a run, if you’re at the receiving end. So, the discussion about deposit insurance should be placed in this broader context of funding risk for the bank. And as Loretta laid out very well, a crucial part of that is the role of the central bank as the lender of last resort, and what it would take for the collateral framework, or the criteria and the rule book for the emergency funding from the central bank, to be done without the stigma issues that Loretta mentioned.

Banks as the Pillars of the Monetary System

Goldstein: I want to finish by thinking about the future of the banking system, and maybe give each one of you a minute to reflect on — are we going towards a different kind of financial system, a different kind of banking system? One thing that we see is more consolidation. As Loretta mentioned before, there was a run from the small banks to the large banks. So maybe we will have fewer and fewer smaller banks going forward.

Something else that comes to mind is digitization and the fact that digital deposits are much easier to withdraw, and maybe the liquidity that banks have is no longer adequate to deal with that. So, where are we going in terms of the future of the banking system?

Shin: Yes, Itay, maybe I can just kick off with a very quick point about the distinctive nature of banks. I mean, banks are distinctive, in that deposits are the main means of payment. So we execute payments by debiting the account of the sender and crediting the account to the receiver, and it’s settled through the central bank’s balance sheet. So in that respect banks are not only bringing in funding and lending — they’re also essential for the monetary system to work.

What we’ve been doing, actually, at the BIS is to use some of the technological innovations. In particular, we have a project called Agora, which is about revamping correspondent banking by using tokenization. Tokenization is this idea that you can have claims being transferred on a programmable platform, and so you can build in contingencies and other features. If we look to the future, my sense is that we will be speaking more and more about the role of banks as the pillars of the monetary system as well as intermediaries that lend.

Mester: Yes; I don’t disagree with that. But I’d also point out that we have these problems periodically that come up in the industry, and there are always people who say it’s the end of the industry, and everything’s going to become non-bank. Well, the banking industry has been around forever, and I think it will change. The regulatory supervisory structure will have to change in order to make sure that we have financial stability, which is crucial for a healthy economy. And the distribution of the size of banks is likely to change because of technological changes.

Some of my own research shows that the efficient size of a bank is much larger now than it used to be. But it doesn’t mean that community banks won’t stay and still do what they do best, which is lend to their local community. It will change over time. What I’m hoping is, in the U.S., we get a little bit of a simpler structure, because it’s very different from that in a lot of other countries. But banks are becoming more and more important in terms of the payment system.

The Fed launched its instant payment system over a year ago, and it’s being built up now in terms of more and more firms becoming customers of Fed now. That’s where things are going, and technology can be very helpful to [enable] more efficient, more safe, and more sound banking. But it also shows that in the speed of the runs that occurred, it also can lead to more challenges. So we are in a very exciting time of change.

But fundamentally, if you think back to the stresses of March 2023, it wasn’t a big esoteric thing that went on. It was just basic poor risk management and weak supervision. Those are things that we all have to take to heart. Whichever side you’re on, if you’re a bank, banker or a regulator/supervisor, we can do the basics better than we showed that we were doing in March 2023.