How can we avoid a third phase of banking turmoil

The writer is president of Queens’ College, Cambridge, and a director of Allianz and Gramercy

US banking tremors are evolving. The first phase of the turmoil, when sudden and massive outflows of deposits from poorly managed and inadequately supervised banks caused spectacular failures, has leveled off.

The current phase, which focuses on the cost of financing and less problematic budgetary issues banks operating in a highly unstable neighborhood, they can also be stabilized. Indeed, it must be if we are to avoid a third phase involving considerably greater financial and economic damage.

Let’s start with the good news. We are unlikely to see the dramatic institutional collapse experienced by Silicon Valley Bank during which $42 billion in deposits flew out in one day and another $100 billion would have flown out the next day if regulators hadn’t shut down the bank.

This good news is due to two main factors. First, through practice rather than legal changes, authorities have signaled that the $250,000 cap on the state’s individual deposit guarantee has been replaced by unlimited coverage. The trick is simple. The Federal Reserve just declared a systemic risk exception. Second, the Fed has opened a funding window that allows banks to trade at par on securities that are worth much less on the market for one year. This reduces the risk that banks will have to sell at a loss to meet deposit outflows and provides them with preferential financing.

This major stabilization was far from perfect as it only addressed part of the stress on the banking system, inflicting collateral damage and unforeseen consequences. Several US regional banks still operate with mismatches between their short-term liabilities and longer-term assets. Their balance sheets are further burdened by shady commercial real estate loans.

Furthermore, they are subject to a regulatory regime that has failed to ensure adequate capital coverage, an error that is magnified by the piecemeal supervision that was detailed in the same Fed filing. assessment of the bankruptcy of SVB. They also remain vulnerable to the Fed’s mismanaged interest rate hike cycle. And all of this risks dampening the banking system’s enthusiasm to extend credit even if the moral hazard is greater.

Fortunately, these banks don’t have as many immediate structural weaknesses as the ones that went bankrupt. Consider, for example, PacWest, which found itself on the corner last week when its stock price plummeted. Its 25% uninsured deposits pale in comparison to what the SVB and the First Republic had. Also, its customer base is substantially more diverse. However, it will have to sort out balance sheet issues and face higher borrowing costs at a time of very nervous markets.

The market mood is not surprising. So far this year, banks with more than $530 billion in assets have failed, already surplus the 2008 total during the global financial crisis after adjusting for inflation. How the First Republic failed is also playing a role. The theoretical alignment of incentives between major players proved insufficient to ensure a timely resolution.

Shareholders saw their holdings lose more than 95% of their value before the bank was acquired by JPMorgan. Markets now readily punish the actions of banks, especially those that talk about weighing “strategic options.” This leaves the door open to vicious circles.

This second phase can also be contained. First, banks need to pay more attention to what they say and generally have very responsive communication with investors – a lesson already learned by some institutions. Second, the Fed needs to strengthen its supervisory regime. Third, public-private resolutions for banks need to be made to work under tighter timelines if needed. Fourth, the public sector must assure markets that, rather than the ad hoc approaches that have dominated hitherto, they will work to revamp both the deposit insurance system and the regulation of banks mistakenly believed to lack systemic threat.

This is necessary if the United States is to avoid a third and significantly more damaging phase of the banking turmoil. If the less problematic banks fail in the coming weeks, the impact on the financial system and the economy would be much more consequential.

Despite an extraordinarily resilient labor market, the US would soon find itself in an otherwise avoidable recession with limited fiscal and monetary policy options. The likelihood of further policy errors would be relevant. And all this just as the slower stress in the non-bank financial sector becomes more evident.