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Too Big to Fail: A look at the dynamics behind the banking headlines

5th Jun 2023
It is an all too common phrase in discussions about the stability of banks, but what makes a bank too big to fail?

Recent high profile European examples such as Credit Suisse, UBS, and the Swiss government’s response raise interesting questions. What factors potentially make a bank too big to fail? Why have governments historically bailed out big banks? And what is the damaging impact of rumours on bank stability?

The collapse of Lehman Brothers during the 2008 financial crisis serves as a stark reminder that the failure of a large financial institution can have far-reaching consequences.  The recent case of Credit Suisse and UBS in Switzerland provides an insightful example of the notion of a bank being too big to fail, and what was done to save it.

 

Size matters

These banks are considered so vital to the Swiss financial system that their failure would have severe repercussions for the national economy. As a result, the Swiss government and regulatory authorities have implemented measures to safeguard these institutions, such as capital injections and increased regulatory oversight. This approach underscores the belief that certain banks are indeed too big to fail.

Several factors can contribute to a bank being deemed “too big to fail.” Size and interconnectedness play a crucial role. A bank’s extensive reach, global presence, and involvement in complex financial transactions can make it difficult to untangle and resolve any issues in the event of a failure. Moreover, a bank’s importance to the overall economy, such as its role in facilitating credit and supporting economic growth, can also contribute to its systemic significance. As seen recently, the potential domino effect on other banks and industries plays a significant role in policymakers’ decisions to intervene.

Throughout history, there have been instances where banks that were on the brink of collapse were bailed out by governments, or other banks to prevent severe economic consequences. The 2008 financial crisis is a prime example, with several major banks requiring government assistance to avoid catastrophic repercussions. These bailouts highlight the perceived systemic importance of these institutions and the potential consequences of their failure. The rationale behind these bailouts is to prevent a complete collapse that could have catastrophic consequences on the economy, including widespread job losses and a deep recession.

 

Rumours

In today’s interconnected world, the power of online, and especially social media, cannot be ignored. Modern-day rumours on social platforms can spread rapidly and cause a significant impact on banks. False information or negative sentiment can trigger a “run” on the bank, leading to mass deposit withdrawals and a loss of confidence in its stability. Such a situation puts unnecessary stress on a bank, further exacerbating its financial woes and potentially pushing it towards failure.

CNN recently reported Western Alliance’s public denial that it was up for sale. The report goes on to say “Western Alliance Bank denied reports that it’s exploring a sale, or has hired an advisor to explore strategic options.”

Shares of the regional bank tumbled 36% on the day of the report, slightly paring back its losses after plunging over 50% at one point on reports that the company is the regional bank latest to explore a potential sale.

It also dragged down the broader stock market: The Dow fell 400 points, or 1.2%, and the S&P 500 sank 0.9%.

 

Choose wisely

When selecting a bank, several factors should be taken into account. Consider the bank’s overall financial health, including its capitalisation, liquidity, and profitability. Assessing the bank’s credit rating, provided by agencies such as Standard & Poor’s, Moody’s, and Fitch Ratings, gives insight into its creditworthiness and ability to meet financial obligations.

Additionally, evaluate the bank’s debit to credit ratio, customer reviews, the breadth of services offered, and the quality of customer support. Other crucial aspects to consider include:

  • The bank’s capital adequacy: This rating measures the bank’s ability to absorb potential losses and maintain a solid financial position, indicating its level of capital in relation to its risk-weighted assets.
  • Liquidity position: This rating assesses the bank’s ability to meet its short-term financial obligations, evaluating its access to liquid assets and funding sources to cover potential cash flow challenges.
  • Debt-to-credit ratio: This rating examines the bank’s level of debt in relation to its overall credit exposure, indicating its leverage and potential vulnerability to default risk.
  • Risk management practices: This rating evaluates the bank’s ability to identify, assess, and mitigate various types of risks, including credit risk, market risk, operational risk, and regulatory compliance, highlighting the effectiveness of its risk management framework.
  • Regulatory compliance: This rating assesses the bank’s adherence to relevant laws, regulations, and industry standards, ensuring that it operates within the legal framework and meets the requirements set by regulatory authorities.

Bank ratings are essential tools to assess the financial strength and stability of a bank. The most commonly used rating agencies, such as Standard & Poor’s, Moody’s, and Fitch Ratings, assign grades to banks based on their analysis of various factors.

Ratings typically range from AAA (highest rating) to D (lowest rating). It is important to understand that higher-rated banks are generally considered more financially stable and reliable.

The concept of a bank being “too big to fail” holds significant implications for financial stability and the overall economy. While historical bailouts have occurred, it is important to note that a bank’s size, systemic importance, and interconnectedness contribute to its “too big to fail” status.

There are also third-party institutions that can help to mitigate the risk that a big bank failure may cause, even with potential government bailouts. Diversification, proximity to information and agility to react can all be beneficial attributes as extensions of banks, and banking services.

 

To find out more about the Banking & Treasury services provided by JTC, please contact Paul Fosse directly or visiting our dedicated page: Treasury

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