The 2023 Banking Turmoil: A Middle-of-the-Road Crisis

The failures earlier this year of a group of midsized U.S. banks grabbed headlines and yielded many questions about the effectiveness of their risk management programs. But how big was this crisis, really, and what was its real impact on financial risk practitioners?

That depends, of course, on whom you ask. In a recent report about the 2023 banking turmoil, the Basel Committee for Banking Supervision described this year’s bank failures as “the most significant system-wide banking stress since the Great Financial Crisis (GFC) in terms of scale and scope.”

Is this observation accurate or an overexaggeration? Before answering this important question, let’s consider the lessons the BCBS stated financial institution should have learned from the spring 2023 fiascoes – which included the failures of SVB, Signature Bank and First Republic Bank, and the UBS bailout of Credit Suisse.

Lessons Learned for Financial Risk Managers

The report contains several lessons that financial risk managers (FRMs) can take to heart. Let’s now paraphrase these lessons, and identify their key takeaways for FRMs:

1. Macroeconomic factors are important. Rising interest rate risk in the banking book, for example, can yield increased credit risk – especially for loans with a variable client rate in combination with zero or low amortization. Generally, the report concluded, banks that fail have insufficiently anticipated regime switches of macroeconomic variables.
   Takeaway for FRMs: understanding economic trends is important.

2. Rapid asset growth is a concern for risk managers, and the same is true for concentration of exposures. Citing the contagion that took place during the “crypto winter” of 2022, the report states that investments in highly volatile cryptocurrencies are a particular red flag.
   Takeaway for FRMs: it’s vital to perform constant benchmarking of the bank’s portfolio breakdown against a peer group “to detect outliers in terms of customer bases, balance sheet, structure (concentration, interest rate risk), asset growth, management and corporate culture.”

3. Contingency funding plans are worthless if not tested. By running such tests, one can determine, for example, whether the eligibility of collateral for (emergency) funding is less than previously assumed. When combined with heavy reliance on short-term uninsured funding, this type of collateral shortfall can be especially toxic.
   Takeaway for FRMs: liquidity risk must be very carefully measured on the eve of any pending crisis, because it’s the most dangerous risk in that type of scenario.

4. Senior management and board members at financial institutions who have little to no risk management experience must be viewed with more skepticism.
   Takeaway for FRMs: idiosyncratic risk is concentrated at the top of the pyramid.

5. Senior management and the board need to be given proper incentives. They must be rewarded for long-term behavior to enhance the value of the bank and to reduce its risks. Short-term incentives can lead to short-term measures that can be detrimental in the long run. For example, the report states, hedging decreases premium costs and generates higher profit in the short term, but also leads to unprotected risk exposures.
   Takeaway for FRMs: understand the latent reasons for suggestions to remove hedges.

6. Banks that fail typically have a dysfunctional relationship with at least one supervisor. An attitude that risk management exercises are “only compliance” is not conducive toward proper management of exposures.
   Takeaway for FRMs: be wary of a corporate culture in which risk management is carried out minimally and mechanically, only to please the supervisor.

7. Viability comes into question once CDS prices explode and/or the rating agencies have downgraded the bank to non-investment grade.
   Takeaway for FRMs: look at your business and risk organization as an outsider does.

Failure is Baked into the Regulatory Cake

Before determining whether the BCBS’ assessment of the 2023 U.S. bank failures is on point or hyperbolic, we should acknowledge two premises about financial disasters.

The first premise is that crises come in many shapes and forms.

When we think of these fiascoes, typically two extremes come to mind: a small crisis that rapidly goes away or an exceptional, international disruption where financial sector problems spill over to the real economy – e.g., the Great Depression in the 1930s, the Russian default in 1998, and more recently, the Great Financial Crisis (GFC) of 2007-2008.

However, it’s also possible to have a “middle-of-the-road” banking crisis – i.e., a serious event that impacts one or two countries but is contained after a few weeks without big, global implications.

So, for simplicity’s sake, let’s say that there are (at least) three types of crises: the small ones, the really big ones and the “in-betweeners.”

Bank failures, moreover, can and will happen. (That, in fact, is our second premise.) Indeed, they must happen from time to time. If a bank is not viable, it should be dismantled, just like any other type of failing business. It’s only then that any selected resolution mechanism can start working.

Marco Folpmers

Of course, once a bank grows toward too-big-to-fail status, failure should be prevented – because such a collapse would have severe implications for the real economy and private consumers. Prevention, though, partly means that banks should be disincentivized from becoming too big. As Mervyn King, the former governor of the Bank of England, once famously said: “If banks are too big to fail, they are too big.”

Where does the BCBS stand, you might ask, with respect to these two premises? Clearly, the Committee subscribes to premise #2. One passage in its report states that the existing regulatory framework is “not calibrated to produce ‘zero failures.’” On the other hand, the BCBS’ also uses strong language to describe the March 2023 banking crisis, calling it the largest systemwide banking crisis, “in scale and scope,” since the GFC.

Simply put, the 2023 crisis is not in the same league as the GFC, so I respectfully – but strongly – disagree. What happened to SVB, Signature Bank, First Republic and Credit Suisse was a “middle-of-the-road” crisis, rather than a full-blown meltdown.

The Fear Index

To illustrate this point, let’s analyze the VIX index – also known as the “fear index” – from 2005 to 2023. The four significant financial fiascoes that occurred during this period are highlighted in the shaded areas (each covering two months) in the graph below.

The VIX Impact of Four Financial Crises: 2005-2023

Source: Yahoo Finance

As depicted in the chart, the VIX skyrocketed to slightly above 80 points during both the September-October 2008 GFC (culminating in the default of Lehman Brothers) and the March-April 2020 COVID-19 pandemic.

The VIX reached 35 points, while the Dow Jones index plunged 800 points, during March-April 2022 – the start of Russia-Ukraine war. The March 2023 banking crisis, meanwhile, brings up the rear of the disasters that occurred from 2005-2023, cresting at around 25 points on the VIX. This indicates that this year’s bank failures can best be described as a moderate and short-term crisis.

Parting Thoughts

The Basel Committee’s BCBS report on the March 2023 crisis not only serves as a useful case study for this year’s bank failures but also provides interesting anecdotes of the Swiss-government-supported rescue of Credit Suisse by UBS.

It clearly illustrates that the Basel capital measures are not calibrated to zero risk and that central banks and governments need to take action once banks reach the point of non-viability. It is also good to know that contagion was relatively limited in these cases.

The BCBS report, however, also comes across as overexaggerated, and the Committee should have provided context by presenting a framework for the classification of banking crises. Criteria for such a classification should include the international reach of a crisis, its impact on the real economy, and its contagion effects.

If the BCBS’ took a reasonable, level-headed approach, it would have omitted unnecessary hyperbole and described the March 2023 banking crisis as it was: an impactul but middle-of-the-road crisis that was not on the same level as the GFC.

Dr. Marco Folpmers (FRM) is a partner for Financial Risk Management at Deloitte the Netherlands.