The real threat to stability is not from bank runs

In a letter to the editor which has recently appeared in the Financial Times (The real threat to stability is not from bank runs, FT, May 19 2023) London Business School's Richard Portes, Anat Admati, George GC Parker Professor of Finance and Economics, Stanford University Graduate School of Business, Stanford, and Martin Hellwig, Director, Max Planck Institute for Research on Collective Goods, Bonn respond to Mervyn King’s proposal for guaranteeing liquidity provision to financial intermediaries (“We need a new approach to bank regulation”, Opinion, FT Weekend, May 13).

Here follows the letter from May 19 2023:

“Mervyn King’s proposal for guaranteeing liquidity provision to financial intermediaries merits serious consideration (“We need a new approach to bank regulation”, Opinion, FT Weekend, May 13). But the former governor of the Bank of England’s suggestion diverts attention from the insolvency underlying what he calls ‘another crisis of confidence in banks.

"The former governor of the Bank of England’s suggestion diverts attention from the insolvency underlying what he calls “another crisis of confidence in banks”.

“The runs on both Silicon Valley Bank and Credit Suisse were triggered by announcements that alerted depositors and other investors to problems affecting their solvency.

“Bank failures in the US, including SVB and First Republic, illustrate the fragility of using deposits and other short-term debt with razor-thin equity funding to make long-term investments. Over an extended period of low interest rates, banks accumulated long-duration, low-yielding assets while paying even lower rates, often zero, on their deposit liabilities. When rates rose, this business model became unsustainable.

“SVB had been insolvent since at least September 2022, shielded by accounting practices that did not revalue its “hold-to-maturity” assets as nominal rates rose. When it had to sell some of these securities, the insolvency became clear.

“Two studies we conducted find that marking to market assets in the US banking system would show losses of close to $2tn, roughly equal to the system’s aggregate equity. Many banks are insolvent. The position may be better in the UK and EU countries, but we need to see the data.

“Providing liquidity to banks at rates much higher than the yields on many of their assets, while guaranteeing all deposits, would just underwrite zombies. They will stagger on, continuing to pay executives and shareholders while possibly gambling for resurrection with highly risky investments. The protracted US savings and loan crisis of the 1980s and 1990s showed how costly this approach can be.

“The immediate policy challenge and threat to financial stability is not primarily runs and illiquidity but rather the weakness and potential insolvencies of many banks, unless and until nominal rates fall sharply.

“Longer term, it is essential to reduce the fragility of the system by requiring much more equity."