Time to let some air out of the banking system?

Since 2008 – when global banking went ‘pop!’ – regulators have been trying to ensure the reinflation of capital in the system. But now, with global policy-makers desperate to boost their economies, Europe, for one, is considering whether to stop pumping up capital – and maybe let some air out.

Since most banks have withstood a string of more recent crises, there’s evidence to suggest current capital levels are adequate. Regulators have unfailingly praised banks for being “a part of the solution” to the economic turmoil resulting from the Covid-19 pandemic. In the fallout from the Ukraine invasion, only Russian banks were seriously wounded. And despite repeated wild swings in energy markets, banks have come through with the mere scratches of credit and market risk losses.

But there are two major exceptions to this testimony to resilience. The first is Credit Suisse. With its strong capital levels, the group’s 2023 collapse took many by surprise. The bank suffered a complete loss of confidence when management blunders exacerbated losses inflicted by the collapse of Greensill and Archegos. Doubting its safety, depositors withdrew their money en masse.

Some regulators point to developing vulnerabilities as the reason capital standards should not dilute – and should strengthen even further

Perhaps a stronger capital position could have persuaded them otherwise. But it seems unlikely.

Which hints at the potential pointlessness of raising capital further.

The other major exception is the string of US regional banks that failed that year and set in train the banking crisis that led to the Swiss bank’s demise. Silicon Valley Bank is often seen as the unfortunate poster child of this regional bank crisis.

Some US regulators say capital wasn’t the issue in SVB’s failure. Rather, it was its liquidity profile. Along with poor interest rate risk management, the bank couldn’t monetise its assets quickly enough to repay fleeing depositors.

And this isn’t the full picture. SVB’s capital levels proved inadequate because they didn’t reflect the risks in its bond portfolio. US regulators are partially solving this problem by removing from the calculation of capital requirements a filter that essentially turned a blind eye to unrealised losses in bond portfolios. Nonetheless, the fix won’t capture similar types of loss found elsewhere in banks’ books – the same ones blamed for SVB’s insolvency.

This panic spread to the health of US regional banks generally, and two further banks failed. Yet US regulators’ fix hands a 3–8% capital reduction to regional banks. The rejig shows how capital standards can account for missing risks while being weaker overall.