Banking: Many possible risks require dire confidence

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.

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 and will repay the capital in accordance with the loan agreements.

Supervision

In South Africa, the SA 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 the permanent capital for the institution, based on the trust that their investment will pay them dividends over time.

All this confidence rests on the ability of banks to manage risks appropriately. The very basis on which banks operate is risky.

They 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 – or funding – duration.

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. Liquidity risk can also emerge when the assets of banks drop in value.

These are the loans made to the public. Defaults on loan repayments require write-offs. Silicon Valley Bank in the US invested heavily in government bonds.

When the rates increased, the capital value of the bonds held by the bank declined. This resulted in a liquidity shortage and a solvency crisis.

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Trigger

Once sufficient risks are triggered, a bank might not survive, because trust will be shattered. Under such circumstances, a curator is appointed to manage the bank’s affairs.

A curator will either manage a bank back to sound health, or wind down its business. 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 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, which can spread beyond the banking system.

Financial contagion refers to the spread of an economic crisis from one market (such as the banking sector) or one country to other markets (like the insurance industry) or other countries.

Under these conditions, confidence in industries or even in countries can dissipate overnight. 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. What can be done to manage these factors?

Management must assess and mitigate risk.

Banks must meet the requirements of supervisors and manage their affairs accordingly.

-Rossouw is visiting professor at the Business School, University of the Witwatersrand

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