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Banking crises and awareness

Situations of financial stress or distress in the financial sector are not new, by far. We remember more easily the big financial crises but banking problems happen with some frequency, at least more than what we expect. They don't necessarily all end up in a full crisis since a multitude of alternatives are used by regulators and financial authorities to overcome the problem and more importantly, avoid contagion to other institutions: extraordinary lending, buy-out, buy-in, merger,... With each new case, the question remains "how to avoid the next one?". And how to deter moral hazard, given the example of salvage just provided.

Among these, the crisis of the savings and loans of the 1980s in the United Stated is a good example, an example that repeated recently with the case of middle banks such as SVB and the others. And the issues are not new, "riding the curve" lending long and borrowing short, when interest rates rise subtantially after a period of historically very low rates.

In the case of SVB, you must add a lack of diversification of clientele and the strong correlation between the abundance of liquidity in low rate periods, and the need to burn cash again in higher interest rate periods, and you have a dangerous cocktail. Moral hazard, incompetence, bad luck... not up to us to judge. The situation of these banks was certainly not unknown. And knowing that a big portion of held loans was of state agencies, there could have been clearly a way to use them as collateral for short-term liquidities.

This situation happened at the same time as another one: the fall of Credit Suisse. A major bank, with international reach, also in terms of investors. After a long series of years with issues, recent events had led to a lack of confidence and massive withdrawals from the bank. A massive infusion by the Swiss National Bank didn't suffice unfortunately and withdrawals continued prompting the authorities to come up with a more drastic solution.

During the crisis of 2008-..., systemic risk appeared as a new important exposure unnamed before, and resulting from the contagion through interconnectedness between banks. An academic article, co-authored by one of the co-founders of FinMetrics, was published in Scientific Reports from Nature in 2013 on the study of default cascades in complex networks, showing how fragility could be linked to the type of structure and degree of interconnectedness, and not only to the strength of the shock.

But the crisis this time, hopefully averted, highlights an additional type of contagion: psychological contagion through the lack of confidence reverberating to other banks, in other countries, not necessarily interconnected mechanically through financial instruments. A systemic risk not because of the grid, but because of banks seen as a system, and the fear - plus the winllingness to earn a higher interest rate in higher inflation environments - that the system couldn't hold the change of paradigm.

Article in L'Agefi Luxembourg about banking crises in 2023

Still, banks are not so abstract as we could imagine, even more in the case of SVB whose balance sheet was simple to understand, and there is no reason why we couldn't see them as just another form of corporate firm where good cash flow management is crucial. For a recent article on the matter, don't hesitate to look at the following publication in l'Agefi Luxembourg: "To be aware...or not to be aware" from Hugues Pirotte.


Some interesting links


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