Four ways to make it easier to wind up failing banks

“A globally active, systemically important bank cannot simply be wound up according to the ‘too big to fail’ plan,” said the Swiss finance minister last weekend. “It would be legal. In practice, however, the economic damage would be considerable.”

Karin Keller-Sutter, fresh from drafting the bailout through the takeover of Credit Suisse, has identified a clear problem. Bank resolution, the supposed gold standard for emergency regulatory action cast in the heat of the great financial crisis of 2007-08, may be mainly decorative.

The bank resolution mechanism clearly needs to be overhauled ahead of the next round of financial turmoil.

The digitized speed of the Silicon Valley bank run revealed deep problems with other contingency measures such as deposit insurance and central bank funding. Days later, Keller-Sutter and colleagues managed to drive Credit Suisse into the arms of UBS. In doing so, however, they eliminated contingent convertible bonds, which were supposed to be above equity in the established hierarchy of liabilities. The Coco, a key new tool in the post-2008 regulatory box, proved unsuitable — or at least vulnerable to the whims of regulators.

Four major adjustments would facilitate the orderly resolution of a bank’s impending insolvency.

As US President Joe Biden hinted this week, regulators first need to factor in the impact on balance sheets of large rate hikes in their stress tests for institutions ahead of periods of monetary tightening, and bring mid-sized banks back under the tighter Dodd-Frank rules to systemically important peers.

Regulators and central banks, too, need to recognize the sheer speed at which an online run on the bank can unfold. A 24/7 crisis requires a 24/7 response. It is no longer sufficient for the US Federal Reserve to limit the opening of its discount window to a few hours a day. The Fed may also consider expanding the range of securities that can be pledged as collateral for loans from the window and making permanent the new Bank Term Funding Program it set up after the SVB implosion.

Thirdly, deposit guarantee schemes need to be adjusted as the current impression is that all deposits are de facto guaranteed. This is tricky. A permanent backstop would increase moral hazard and license banks to pursue risky strategies. A temporary backstop on all deposits, as proposed by Sheila Bair, former chair of the US Federal Deposit Insurance Corporation, would require careful planning to avoid possible runs on fragile banks as the guarantee period nears its end.

What is clear is that if the coverage of mutual deposit insurance schemes expands, banks will have to pay a higher price to participate. Bank deposit safety rules need to be tightened and strengthened against later attempts to relax them.

Finally, following the rescue of Credit Suisse, banking regulators will need to codify the investor hierarchy and ensure it is applied consistently across jurisdictions.

The SVB and Credit Suisse cases have drowned out banks’ calls for rules to be relaxed and should dampen governments’ desire to use looser regulation as a competitive tool. A safer, if less profitable, banking system built on fortress-like capital structures is again the goal.

But the recent turmoil is a reminder that local politics and pragmatism trump purism when banks falter. Such ad hoc decisions fuel further uncertainty. More than a year elapsed between the initial shock of the credit crunch in 2007 and the collapse of Lehman Brothers in 2008. Now would be a good time to strengthen the predictive framework that should prevent a repeat of this crisis before the next quake.