US bank runs hold key lessons for India

Indian regulators should not be blind to risks in the underbelly of the system. And bank boards must challenge bank managements on their business models

The collapse of a few mid-sized American banks and the crisis of confidence in Credit Suisse, a major European bank — all in the span of just one week — threatened to snowball into another global financial crisis. Thankfully, authorities on both sides of the Atlantic mounted swift rescues to contain the contagion. For now, nerves seem to have been calmed but we can’t be too sure that the crisis has blown over. The persisting anxiety raises two sets of questions for us in India. What are its implications for our macroeconomic management, and what lessons do we learn from the recent turmoil?

A bank will survive only as long as it can carry the bluff that it can redeem all deposits even if it were to do so all at once. To SVB’s misfortune, its bluff got called. Avoiding that fate is a perennial challenge for a bank (AFP)

The macroeconomic implications for us will depend on how the Federal Reserve responds to the evolving situation. Before Silicon Valley Bank (SVB) emerged on the scene, the Fed made an unequivocal commitment to return US inflation to the target of 2% from its current level of 6%. Will it now back off from that commitment out of concerns that further tightening will push more banks to breaking point? Will it be less aggressive in rate hikes as some tightening will happen automatically because banks, dented in confidence, will retrench lending?

This uncertainty heightens the need for India to be vigilant. Should any new hiccup anywhere in the United States (US) financial system ignite a system-wide panic, its tremors will be felt around the world. There will be a flight to safety and capital will flee emerging markets, leaving in its trail exchange rate volatility and financial instability. That America should be seen as a safe haven for money even as it is the epicentre of the crisis is bizarre. But that’s the way of the world — a reflection of the might of the US economy and of the dollar.

Another concern for us is that the recent financial turbulence has increased the likelihood of a recession in the US. Should that materialise, it will hit our export demand, which we can ill afford at a time when we should be firing on all cylinders.

As for lessons, there are many but I will focus on two.

The failure of SVB is an example of a digital-age bank run. The old model of panicky depositors queuing outside a bank branch to withdraw their money is passé. Now social media can spread information — or misinformation — in a jiffy, and people can withdraw their money by hitting a button, anytime, anywhere. It is this awareness of life in the digital age that pushed the Federal Deposit Insurance Corporation (FDIC) to take over SVB in the middle of a workday rather than wait for close of business, as was the old practice.

Several takeaways flow from this. First, regulators and supervisors have to be ever vigilant, tracking the social media flow to be able to respond in real time. They need to have a standard operating procedure for bank rescues. One of the problems with the SVB rescue was that under its regulatory mandate, it was not required to have a resolution plan. That should no longer be acceptable. All banks must be mandated to put in place a resolution plan — a living will of sorts — which can be rolled out in quick order. Most importantly, the authorities must communicate quickly, credibly and unambiguously to douse the fires.

A second big lesson for regulators is a reiteration of the standard homily that they should expect risk from the most unexpected corners. At one level, SVB behaved like any good regional bank should. It networked with Bay Area start-ups, took deposits from them, and lent money for their businesses. When loan demand was low, it invested the surplus in safe, long-dated securities.

But in pursuing this business model, SVB failed to guard against two main risks. The first is concentration risk. A large proportion of SVB’s deposits was from technology companies and typically far higher in size than the deposit insurance cover of $250,000. In a downturn, all its clients got into a funding crunch simultaneously and rushed to withdraw their deposits.

In India, our urban cooperative banks (UCBs) are typically prone to concentration risk. A UCB servicing sugarcane farmers for both deposits and credit, for example, gets into trouble when the sugarcane crop fails.

The second risk that SVB confronted was duration risk. Not having liquid cash to redeem the deposits, SVB was forced to sell its securities. Those securities fell in value because of the rapid interest rate tightening by the Fed. SVB nevertheless resorted to a fire sale which exposed its fragility. Depositors got even more panicky, especially because they had no insurance cover. And that set off a vicious cycle. It’s a different matter that if SVB was able to hold the securities to their maturity, it would have incurred no loss. Maturity transformation of this kind — short-duration deposits funding long-duration assets — is a normal part of the banking business. But SVB carried it too far, without hedging for risk.

The lesson for regulators and supervisors is that they should not be blind to lurking risks in the underbelly of the system. And the lesson for bank boards is not to succumb to cognitive capture and constantly challenge bank managements on their business models.

A bank, it must be remembered, is a confidence trick. It will survive only as long as it can carry the bluff that it can redeem all deposits even if it were to do so all at once. To SVB’s misfortune, its bluff got called. Avoiding that fate is a perennial challenge for a bank.

Duvvuri Subbarao is former governor, Reserve Bank of India The views expressed are personal