Introduction
The banking industry and its regulators continue to adjust to an increasingly turbulent world. A sector grown used to easy money derived from quantitative easing is now facing rising geopolitical risk, deglobalisation and inflation whilst simultaneously dealing with the last wave of reforms following the global financial crisis. These headwinds arguably caused the bank failures of March 2023 and will drive future regulatory change.
The end of cheap money
Looking back, the era of cheap money that started following the global financial crisis of 2008–09 appears to have come to an end. That crisis and latterly the economic fallout of COVID-19 were managed highly successfully by governments in most developed nations. Liquidity constraints were met by unprecedented public sector support – which served as a palliative to the immediate crisis, but also resulted in massive increases in sovereign debt. These actions have sowed the seeds of the current inflationary environment and the deleveraging that now inevitably needs to follow.
Starting from stronger balance sheets than in 2009, and largely cushioned from the immediate effects of the pandemic by the actions taken by regulators, banks came through the COVID-19 crisis relatively unscarred, and the wave of governmental support deferred, if not eliminated, the wave of restructurings and liquidations that might otherwise have been expected.
But there is a price to be paid for cheap money. Rising inflation, and with it interest rates, have curtailed government support and begun to create solvency difficulties for heavily indebted borrowers in the corporate and real estate sectors. Governments and central banks will be walking a tightrope over the next few years to return the role of financing to the market without triggering a debt crisis.
Restructurings
In the banking sector, an increase in the level of defaults is inevitable. Higher interest rates will be the immediate catalyst for many restructurings. In 2024 and beyond, a wave of corporate failures and personal bankruptcy is likely to emerge. Pressure on banks’ restructuring capacity is likely to grow as responsibility for financing, and with it for work-outs, is passed back to the private sector. Banks will need to prepare to deal with that wave at scale, whilst maintaining appropriate controls to ensure the fair treatment of their customers. Mechanisms to clean up non-performing assets will likely also remain important: private credit providers, which are increasingly prominent in the market, will have a major part to play here, but will be subject to regulatory focus given their increasing systemic importance.
Regulators will expect firms to have learnt the lessons of past foreclosure and restructuring scandals. Furthermore, the exercise of lenders’ rights against real economy participants – particularly individuals and SMEs – will remain highly politically sensitive. That sensitivity is likely to make itself felt through continued barriers to the enforcement of lenders’ rights – be they legislative, regulatory (moratoria, and also conduct-derived impediments to rapid workouts) or reputational. In this environment, reconciling banks’ prudential and conduct obligations may become increasingly challenging.
Prudence, provisioning and prudential regulation
Banks entered this new phase with strong balance sheets (in part due to the post-crisis Basel reforms). They have benefited from a welcome resurgence in net interest income (the upside of increasing interest rates), but suffered from diminishing valuations in their holdings of fixed income assets. Near-term, risk management against interest rate risk has come into focus – the failure of Silicon Valley Bank was largely down to its failure to hedge against the loss in value of its assets, highlighting a gap in US bank regulation that will now be filled.
Banks will need to look to make provisions for defaults as well. They will also feel the scrutiny of investors and rating agencies, which will want to understand banks’ assessments of impairments and will view regulatory ratios with greater scepticism.
Bank regulation becomes political in a recession. Depending on the depth of any recession, the current wave of Basel Accord implementation (currently scheduled for 2025 in the UK and Europe, with a three-year transitional regime to full implementation) may be deferred. It also seems likely that there will be challenges to the US implementation of the Accord.
In the UK, ring-fencing remains under review, with some liberalisation on the horizon. A housing crisis may yet cast doubt over the prudence of ring-fencing measures, which have forced UK retail banks to recycle deposits into UK-situs mortgage and consumer debt.
Revisiting resolution
In March 2023, Silicon Valley Bank and Signature Bank in the US failed, closely followed by the rescue of Credit Suisse, which was sold to UBS. The resolutions of all three were successful, in that each was resolved without significant disruption to financial stability; however, each raised a number of questions about resolution – and regulation – more widely.
Perhaps the most important lesson of the failures was the increased vulnerability of banks to runs in the information age. Social media can now precipitate bank runs, and 24-hour electronic account access means that, once a run is underway, a bank’s ability to meet outflows can be measured in hours, not days or weeks. Existing liquidity coverage requirements look inadequate against the speed of recent runs.
Furthermore, the quantitative approach to bank failure (looking at capital and liquidity ratios as the threshold against which a bank is considered to have failed) was demonstrated to be redundant in the case of Credit Suisse, which needed resolving whilst compliant with both its solvency and liquidity requirements. In each of the three cases, the expected playbook for resolution was not followed, and in the US there was a degree of public sector support provided, raising the moral hazard issues that resolution was intended to eliminate.
Together these raise significant questions for regulators:
- Should depositor protection be extended significantly to forestall runs?
- Should liquidity coverage requirements be tightened?
- How should banks and central banks position themselves to meet emergency liquidity demands and maintain depositor confidence?
- How should regulators be empowered to intervene early to resolve banks that simply have no long-term viability?
It seems likely that there will be medium- to long-term changes to the regulatory framework to address these questions.
Deglobalisation and fragmentation
In light of geopolitical events, globalisation feels to be in abeyance, if not full retreat. Following many banks’ exit from Russia, continued tensions between the East and West may put similar pressures on banks active in China and the West. For international banks, the increased polarisation of the world is generally felt through regulatory fragmentation. International standard setters tend to be less influential in times of low international political consensus, and regulatory fragmentation increases.
Future challenges
ESG is a bellwether for the deglobalisation trend. Europe has led on the creation of a regulatory framework for ESG, with the UK following and the US a fair distance behind. Progress has been slowed not only by the energy crisis and tougher macroeconomic environment, but also by an increasingly polarised position internationally – there remains a lack of consensus not only between developed and emerging markets, but also among the developed markets (particularly between the US and EU). Banks have made progress to build out their governance, risk management, disclosure and product level expertise in ESG, and navigate the pitfalls around greenwashing and compliance, but are caught in the crossfire of international polarisation.
Regulatory focus on banks’ technology platforms is also likely to continue, via incoming standards on operational resilience and cloud providers. Governments and regulators are focused ever closer on the oligopoly of major IT providers to the financial sector given their increased concentration and the ever greater risks their failure would pose to the financial system, and are starting to turn their attention to the risks that AI may pose.
