March 2023 was a rude awakening for global financial stability. First came  on 10 March, the second-largest bank failure in US history. Then UBS and the Swiss authorities on 19 March.

Viral Acharya, NYU professor and former deputy governor of the Reserve Bank of India (RBI), points out that few lessons have been learned since the 2008 crisis and the European sovereign debt crisis. “We are still responding to bank failures after the stress is materialising, rather than recognising the stresses ahead of time and strengthening the system to have the buffers to deal with these losses,” he says in an interview.

In a recent book (co-authored with Raghuram Rajan, Rahul Chauhan and Sascha Steffen), the economist examined how commercial banks reacted to changes in the size of the Federal Reserve’s (Fed’s) balance sheet. His conclusion: “The monetary stimulus tends to make banks very fragile in their liabilities.” Essentially, he explains, the expansion of the Fed’s balance sheet has inflated uninsured deposits, or bank deposits that exceed the limit of protection offered by national deposit insurance schemes. This has put increased pressure on commercial banks.

In this context, Acharya identifies several problems: “If inflation rises, [and] interest rates rise, then [banks] make losses on their loans and securities. And if these losses are large enough, they could experience what Silicon Valley Bank and First Republic Bank did last year in March and April 2023. The second problem could just be a solvency problem. Many banks are looking at substantial losses of their commercial real estate. And if these losses materialise, and they threaten the solvency of the bank, then--again--these uninsured depositors may run out.”

What can be done?

The NYU professor has a couple of recommendations for policymakers and financial regulators. Firstly, he calls for increased vigilance on the part of regulators, who should act on market signals that indicate losses of confidence. “Proactive supervision and regulation” are required, he says.

Secondly, he says, it’s necessary to “acknowledge that the monetary and the fiscal stimulus have expanded the base of uninsured demandable deposits in banks, that there is going to be fragility if shocks materialise--and therefore they have to be prepared ahead of time.” The US has focused its regulatory efforts on big banks, says Acharya, but they shouldn’t neglect the rest: “the mid-size and the small banks, which have been left outside of some of the most stringent regulations--that is where the stresses are beginning to show now.”

“What has not been done,” he adds, “is to recognise explicitly on the balance sheet of banks that these interest rate losses and the commercial real estate losses are going to manifest. They are still being recognised in a gradual manner over time--whereas it’s apparent to everyone that these losses are very large. So an alternative approach would be to stress-test the system or do an asset quality review, recognise the losses ahead of time and then figure out ways to recapitalise the system, so that you build trust and confidence--not with a federal backstop, but with the intrinsic quality of the bank itself.

In Europe

Credit Suisse’s problems were a little different, says the economist. “It was just a business model that had been faltering for a while. When other problems arose, the uninsured depositors also woke up and pulled their money out of that bank.” He expresses some surprise that, even though the bank had lost more than 50% of its stock market valuation since February 2021, “we didn’t act in time.”

On the subject of lessons learned, what can Europe take away from the Credit Suisse debacle? Because--as confirmed by Diane Pierret, finance professor at the University of Luxembourg--the European banking sector is certainly not immune to future turbulence.

“The European stress tests focus on the active part of the balance sheet, with very detailed data--but there is little information on the liabilities,” she points out, “either the proportion of uninsured deposits or the origin of depositors. A lack of diversification of liabilities can, if accompanied by a large base of uninsured deposits, make banks much more vulnerable to the slightest shock.”

“The current configuration is robust”

Asked for comment, Luxembourg’s financial regulator (CSSF) referred to the conclusions of the Basel Committee on Banking Supervision, of which it is a member. In its “Report on the Banking Turbulence of 2023,” the Basel Committee stresses that it’s important for supervisors to deepen their understanding of the viability of banking business models. This means identifying banks that deviate significantly from their peers in terms of customer base, balance sheet structure, asset growth and corporate culture--but also to understand and assess the composition of deposits and depositor loyalty, in order to identify and manage the risks associated with these liabilities.

“We fully share the conclusions of this report,” says the CSSF. The Luxembourg authority also points out that the Single Supervisory Mechanism--Europe’s banking supervision system--has examined whether changes in supervision are necessary. “The main conclusion is that the current configuration is robust, but that supervisory teams need to be made aware of the need for vigilance.”

This article in Paperjam. It has been translated and edited for Delano.