A Professor of Economics at the London Business School, Lucrezia Reichlin, has disclosed that other banking crises could happen, especially if Central Banks continue to tighten monetary policy.
The economist asserted that banking crises cannot be prevented under all circumstances, at least not in the current system of fractional reserves – where loans are not required to be fully backed by deposits, adding that; “the recent crisis is a painful reminder of the fundamental instability of banks’ business model.”
Talking about the subject ‘Early lessons from the recent banking turmoil’ championed by the International Monetary Fund, Ms. Reichlin expressed the belief that banks are prepared and well equipped to deal with global liquidity shocks through Central Banks’ interventions.
“In principle, we also have tools to deal with the insolvency of a single institution. However, those crises are rarely managed in an orderly way. Today, if the world economy were to plunge into a deep recession, we are likely to see many cases of institutions facing solvency problems that will test this assertion.”
Lucrezia Reichlin
Ms. Reichlin further noted that the Credit Suisse incident raises concerns about whether Central Banks can be confident that problems can be resolved following the rulebook.
“If a bank is failing, the regulator can seek resolution with a bail-in or a bailout. A bail-in in theory is a good option to protect taxpayers, but in some cases a bailout may be wiser. The way to think about the choice is that a bail-in may cause financial instability while a bailout causes moral hazard and is an implicit subsidy to the banking sector.”
Lucrezia Reichlin
In many cases, the Economist pointed out that a national regulator frequently facilitates a merger with a national bank, either through moral persuasion, subsidy, or both, in order to address the crisis of one bank.
This was the case in Switzerland, where UBS was encouraged by the regulator to absorb Credit Suisse at a very unfavorable exchange for Credit Suisse shareholders. “Such a solution is not always feasible,” she said.
Since UBS is now the only national bank in Switzerland, she pointed out that another merger would not be feasible and that a cross-border merger would involve authorities with different national interests.
Early Lessons From The Recent Volatility In The Financial Sector
Lucrezia Reichlin cited the US Silicon Valley Bank debacle as inspiration and said that the Fed’s post-mortem investigation found that risk management, oversight, and regulation failed.
“Two lessons can be drawn from that. The first is that not only big banks but also midsize banks can create contagion; when this happens, intervention by public authorities is required to stop it.
“The second lesson is that all deposits are potentially volatile; partial deposit insurance is not credible. In the case of Silicon Valley Bank, all depositors were bailed out, and this was a gift to wealthy depositors. I expect other banking crises to happen, especially if central banks continue to tighten monetary policy”
Lucrezia Reichlin
According to the Economist, banking crises cannot be entirely avoided, at least not under a fractional reserve system like the one currently being faced – where loans don’t need to be fully backed by deposits.
The current financial crisis, she said, serves as a stinging reminder of the underlying instability of the banking industry
“One question is whether the crisis management framework we have in place can prevent generalized contagion when one institution fails. I believe that we’re well equipped to face generalized liquidity crises through central banks’ interventions. In recent years, central banks have proactively intervened as liquidity providers and learned to do this in a timelier manner than in the past.
“In principle, we also have tools to deal with the insolvency of a single institution. However, those crises are rarely managed in an orderly way. Today, if the world economy were to plunge into a deep recession, we are likely to see many cases of institutions facing solvency problems that will test this assertion. The Credit Suisse episode rings an alarm on whether we can be confident that problems can be solved following the rulebook.”
Ms. Lucrezia Reichlin
Reichlin further revealed that if a bank is failing, the regulator can seek resolution with a bail-in or a bailout, stating that; “a bail-in theory is a good option to protect taxpayers, but in some cases a bailout may be wiser.”
“The way to think about the choice is that a bail-in may cause financial instability while a bailout causes moral hazard and is an implicit subsidy to the banking sector.”
Lucrezia Reichlin
Read also: BoG Contemplates Another Policy Rate Hikes To Curb Inflation
