More tick-box regulations won’t save us from a financial crisis
After the fall of both Silicon Valley Bank and Credit Suisse, the instinct will be to double down on new rules. Instead, banks need to learn to stabilise their risks, writes Mary O’Connor.
Last month, the banking world was in for a shock. Both Silicon Valley Bank and Credit Suisse fell by the wayside, highlighting some of the inherent weaknesses in our financial systems.
One of the biggest challenges is an over-reliance on prescriptive rules, often with little focus on the underlying risks of specific institutions. Simply requiring banks to hold more capital – without better risk management – won’t generate confidence in the markets. It creates a government backstop as a crutch to protect consumers or specific sectors, while rewarding risk takers and creating moral hazard.
Crucially, the combination of tick box regulation and micro-management of large banks and insurance firms has been coupled with a lack of rules for non-banking financial institutions. There is no comprehensive system which encourages the financial sector to seek support from other private financial institutions, rather than looking for government bailouts when things go wrong.
Rule changes alone will not solve the problems in the system which have been laid bare. It is also unlikely that raising the guaranteed bank deposit limit, as suggested by Andrew Bailey last week, will be enough. However, there is one obvious, simple and robust option available.
Insurance and non-bank capital can, and should be, used more widely to support our financial system by reducing risk and opening up new areas for growth. This cannot provide all the answers, but with regulatory backing, it can increase resilience and reduce the size of potential bailouts.
Banks fundamentally seek to balance two kinds of risk: short-term deposits – as opposed to longer-term loans – and the amount of risky assets they have compared to capital at hand.
Other financial products, such as insurance, can help to manage both. When Silicon Valley Bank went bust, investors across the world were worried about cash above the limit protected by the government. For many, this meant the life or death of their firms.
Insurance can provide support for deposits above the government guaranteed limit, as long as the bank has robust risk systems, and it can also insure banking portfolios for liquidity or non-payment, which reduces systemic risk.
Similarly, when pools of risks are well understood, they can be insured and those risks can effectively be mitigated for purposes of bank capital models and risk management. This works very well for mortgages, loans with high credit quality, loans concentrated in a single geographic area (as the insurance book will be more diverse) and investments with a longer duration than the institution’s risk appetite.
Rigid solvency rules mean that billions of dollars of long term insurance and retirement capital are not being invested in a way that could shore up confidence in the financial system.
One of the biggest changes in the financial system after 2008 has been the growth of non-bank financial institutions. According to the Financial Stability Board, the sector has grown by 141 per cent between 2008 and 2021, reaching USD239.3 trillion in global financial assets. However, access to this type of credit can be impossible for smaller companies – such as the tech firms who had money with SVB. More importantly, many of these borrowers are risk averse; they want to know that these lenders will support them over the long term.
It may sound counterintuitive but a final sea change in the investment world is the need to shift portfolios into private and illiquid assets. This has been happening with institutional investors for years; private individuals and companies will increasingly be seeking to add these assets to their portfolios. There are significant challenges to ensuring that these assets are diversified, high quality and liquid enough for retail investors. Insurance can provide a solution for all these issues.
It is clear that we need to overhaul our regulations, and regulators, to reduce risk and open up new areas for growth in order to meet the needs of our changing economy. At the same time, the financial sector itself needs to do more to create robustness and confidence, and to demonstrate to society that it can be successful without constant government support and bailouts.