Reforms of the financial crisis after 2008 did not solve the problem of “too big to fail” banks

London (CNN) Regulation that was introduced after the financial crisis in 2008 was supposed to make bank rescue packages a thing of the past. But the biggest test so far has revealed some serious flaws.

In what feels like deja-vu, governments have had to step in as lenders of last resort prevent the recent turmoil in the banking sector from escalating into a full-blown crisis. By using public funds to prop up ailing private institutions, they have exposed the enormous risks that bank failures still pose to taxpayers and the wider financial system.

“I have argued for years that the biggest banks in the world are still too big to fail. That question is now beyond doubt,” Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, told broadcaster CBS on Sunday.

Karin Keller-Sutter, Switzerland’s finance minister, hit the mark when she said restructuring difficult Swiss credit (CS) in line with internationally agreed guidelines after 2008 “would probably have triggered an international financial crisis.”

“I have come to the realization in recent weeks that a globally active, systemically important bank cannot simply be liquidated according to the ‘too big to fail’ plan,” Keller-Sutter told the Swiss newspaper Neue Z├╝rcher Zeitung. “Legally, this will be possible. In practice, however, the financial damage will be significant.”

Keller-Sutter was at the center of a government-orchestrated rescue of Credit Suisse by its larger rival UBS (UBS) earlier this month. Swiss authorities decided the lender, which had been struggling for years, needed an emergency takeover after the sudden failure of Silicon Valley Bank in the US rattled banking investors around the world.

Swiss Finance Minister Karin Keller-Sutter, center, speaks during a press conference in Bern, Switzerland, March 19, 2023.

But implementing the deal could eat up billions of dollars of public money through loans and guarantees. It raises uncomfortable questions about whether much-acclaimed regulatory reforms have really made the financial system more stable and less of a threat to the public sector.

Global standards for dealing with failing “too big to fail” banks were a key part of the regulatory package introduced after the global financial crisis. They were designed to make it possible to wind up a major bank without destabilizing the financial system or exposing taxpayers to the risk of losses.

Nevertheless, when several lenders ran into trouble this month, “regulators didn’t use the mechanisms they promised us would work,” said Anat Admati, a finance and economics professor at the Stanford Graduate School of Business. “Too big to fail is still a problem. It was never solved.”

“Still a bailout”

When it came to Credit Suisse, the Swiss government judged a bailout from UBS to be the only viable option, even though it has left the country’s economy vulnerable to a single massive lender.

Although some investors in Credit Suisse bonds lost everything, Swiss taxpayers are still on the hook for up to 9 billion Swiss francs ($9.8 billion) of potential losses arising from certain Credit Suisse assets.

The government has also explicitly guaranteed a lifeline of 100 billion Swiss francs ($109 billion) to UBS, should it need it, although it can be repaid.

Similarly, US regulators have had to take unprecedented steps that undermined post-crisis rules to ensure that SVB’s collapse did not spill over into a wider banking meltdown.

A Brinks armored truck parked outside SVB in Santa Clara, California, USA on March 10, 2023.

In an extraordinary move, the Federal Deposit Insurance Corporation guaranteed all SVB deposits – including those above the usual $250,000 threshold per person. This limit was enshrined in law by the Dodd-Frank Act of 2010.

The money to this will come from a fund that the banks pay into, rather than from taxpayers. But the move has nevertheless sparked debate about whether this constitutes a rescue package.

“They say it’s not a bailout because industry will pay. It’s still a bailout, whoever pays,” Stanford’s Admati said.

Alongside this, the Fed launched an emergency loan facility for banks after the collapse of SVB and Signature Bank to prevent more failures, exposing the central bank to risky loans, according to Admati.

“It’s a way of maintaining [the banking system] from cracking, but that doesn’t make it any healthier,” she said.

Aaron Klein, a former US Treasury secretary who worked on the Dodd-Frank reforms, is worried about the precedent that has been set.

“Bailouts beget bailouts,” Klein, now a senior fellow in economic studies at the Brookings Institution, told CNN. “It’s hard to change course once you start bailing people out.”

Headquarters of the US Federal Deposit Insurance Corporation

Are the banks safe enough?

Even as existing rules have been ignored, the recent bank failures have some lawmakers and regulators arguing that banking regulation must tightened. Although banks are on some measures more resilient than they were before the global financial crisis, recent turmoil has given regulators pause.

Michael Barr, the Fed’s deputy chairman for supervision, told the US Senate Banking Committee on Tuesday that rules for banks needed to be strengthened. The Swiss government, for its part, announced on Wednesday a “comprehensive evaluation of the too-big-to-fail framework,” the findings of which will be reported to parliament.

And Sam Woods, deputy governor for prudential regulation at the Bank of England, has told UK lawmakers that there could be a question of whether banks are required to have enough cash on hand or readily available.

“A striking feature of the Silicon Valley Bank run, but not so much of Credit Suisse, was the speed at which it took place,” he said on Tuesday. “I think we need to look back at these outflow rates … and ask what have we learned.”

Some of this cuts to the heart of the banks business model. Lenders are only required to set aside part of the money deposited with them. The rest is lent out at a higher interest rate or invested, because that is how big banks make most of their profits.

This means that any institution whose depositors want to withdraw their cash at the same time will be in trouble.

Removing the risk of a bank run entirely would require lenders to hold 100% of all deposits in cash or reserves at central banks. But regulators do not see this as a desirable outcome.

“We don’t want to operate a zero-error regime, because there will be some significant costs in terms of the availability of lending to the economy,” Woods said. “There is a trade-off that is made in all regulations.”

There are less drastic ways to make banks safer. Requiring lenders to fund themselves with more equity and less debt would be one approach, according to John Vickers, who chaired the independent commission that reviewed UK banking regulation after the 2008 crisis.

They would then “have more equity to absorb losses,” he told CNN.

Banks should also undergo “much tougher, more transparent” tests to determine the extent to which they could withstand losses in various adverse scenarios, given the market value of their capital, said Vickers, now an economics professor at Oxford University.

“Undoubtedly, great progress was made in the reforms after the crisis in 2008/2009, but in my view [they] didn’t go far enough.”

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