The bankruptcy of two American banks, Silicon Valley Bank (SVB) and Signature Bank, has raised concerns about a possible contagion within the global banking system. Governments worldwide fear that this bankruptcy may be just the beginning and could trigger a global banking crisis. However on the other side of the pond, the French Minister of Economy, Bruno Le Maire, reassured the public by stating that French banks are stable and are unlikely to suffer the same fate as US banks, SVB and Signature Bank.
The modern banking system offers numerous advantages, particularly in terms of speed and efficiency of financial transactions. However, there are also significant systemic risks that could impact the global economy. These risks can manifest in various forms, such as the failure of large banks, financial market volatility, or the overvaluation of financial assets. But what could be the systemic risks of the modern banking system?
Several factors pose significant systemic risks to the modern banking system:
Risks related to the interconnectivity of institutions:
The interconnectivity of financial institutions refers to the complex network of relationships and interdependencies between banks and other financial institutions. This interconnectivity can be attributed to various factors, such as interbank lending and borrowing, joint investments, operations in financial markets, and derivatives. Interconnectivity can have benefits, such as risk distribution and market efficiency, but it also presents significant systemic risks.
Financial contagion and domino effect
The interdependence between financial institutions means that a bankruptcy or financial crisis affecting one bank can quickly spread to other banks and financial institutions. This phenomenon, called financial contagion, can turn a localized problem into a broader financial crisis and destabilize the entire financial system. When a bank suffers significant losses or goes bankrupt, it can have a domino effect on other banks and financial institutions with which it is interconnected. This can lead to liquidity and solvency issues for these banks, and potentially to cascading bankruptcies.
Concentration, opacity, and complexity
Interconnectivity can also lead to a concentration of risk among a small number of large financial institutions, often called "too big to fail." If these institutions encounter difficulties, they can threaten the stability of the entire financial system due to their size and importance. This concentration makes the financial system more opaque and complex, complicating risk monitoring and regulation by financial authorities. It is often difficult to track and understand risk exposures between different institutions, which can hinder efforts to prevent financial crises.
Systemic risks related to sovereign debt
Sovereign debt refers to the debt incurred by a government to finance its expenditures. Investors typically purchase sovereign bonds, as they are considered relatively safe investments, particularly when the issuers are countries with strong creditworthiness. However, sovereign debt can also pose systemic risks to the modern banking system, especially when investors' confidence in a government's ability to repay its debt is shaken.
Bank exposure and sovereign debt crisis:
Banks often hold significant amounts of sovereign bonds, particularly those of their own country, due to their "safe haven" status and regulatory requirements. In the event of a sovereign debt crisis, the value of these bonds can drop substantially, causing significant losses for banks and jeopardizing their solvency.
Moreover, when investors begin to doubt a government's creditworthiness, they may sell their sovereign bonds, which raises interest rates and exacerbates the debt burden for the government. If the situation worsens, it can trigger a sovereign debt crisis, where a government is no longer able to repay its debt or raise new funds in financial markets.
Limited government support and contagion
When a government faces a sovereign debt crisis, its ability to support its struggling banking system may be limited. This can make banks more vulnerable to financial shocks and exacerbate the economic crisis. A sovereign debt crisis in one country can quickly spread to other countries, particularly when these countries are also perceived as having high debt levels or solvency issues. This can lead to contagion in financial markets and impact the entire banking system.
Risks related to liquidity crisis
Liquidity is a financial institution's ability to meet its short-term obligations, including converting its assets to cash to meet customer withdrawal demands and other financing needs. A liquidity crisis occurs when financial institutions, particularly banks, struggle to obtain liquidity due to a lack of confidence or tightening market conditions.
Tightening of financial markets and rush to withdrawals
Banks often rely on financial markets for short-term financing, such as borrowing from the interbank money market or issuing short-term securities. In times of stress in financial markets, borrowing costs can increase, and banks may struggle to obtain liquidity. This can make them more vulnerable to financial shocks and exacerbate liquidity problems within the banking system.
A run on withdrawals occurs when bank customers massively withdraw their deposits due to fears about a bank's solvency or stability. If a bank does not have enough liquidity to meet these demands, it may be forced to sell assets at prices lower than their actual value, which can worsen its financial situation and potentially lead to bankruptcy.
Repercussions on the real economy and contagion
A liquidity crisis in the banking sector can have significant repercussions on the real economy, as banks play a central role in financing businesses and households. If banks face liquidity problems, they may be forced to reduce lending, which can lead to a credit contraction and an economic growth slowdown.
A liquidity crisis affecting one bank or a group of banks can quickly spread to other financial institutions due to the interconnectedness of the banking system. Liquidity problems can cause a loss of confidence in the financial system, leading to increased borrowing costs and difficulties accessing liquidity for the entire sector.
Risks related to financial bubbles
Financial bubbles occur when asset prices, such as stocks, real estate, or other investments, rapidly increase and exceed their intrinsic value due to excessive optimism and speculation by investors. Financial bubbles can pose systemic risks to the modern banking system when they burst and cause a sharp drop in asset prices.
Credit contraction and overexposure
Banks are often involved in financing assets with inflated prices due to a financial bubble, for example, by granting mortgage loans during a real estate bubble. When the bubble bursts and asset prices drop, banks may face an increase in payment defaults and a deterioration in their loan portfolio's quality. As a result, they may be forced to tighten credit conditions and reduce the amount of loans granted, leading to credit contraction and economic growth slowdown.
Moreover, banks often expose themselves through investments, financing, or stakes in companies and startups. When a financial bubble bursts, the value of assets held by banks and other financial institutions can drop rapidly, leading to significant losses. These losses can harm the banks' solvency and, in extreme cases, cause bank failures.
Financial contagion and effects on macroeconomic stability
The bursting of a financial bubble can cause a loss of confidence in the financial system and lead to financial contagion, where solvency and liquidity problems spread from one financial institution to another. This can exacerbate the financial crisis and make it more difficult to stabilize the banking system.
This can have significant repercussions on macroeconomic stability, as it can lead to a recession or economic slowdown. Households and businesses may be affected by a decrease in the value of their assets and a reduction in access to credit, which can reduce consumption, investment, and job creation.
Cyber risks and cyber attacks
Although cyber risks are more often associated with emerging sectors such as cryptocurrencies (blockchain and exchange hacks) and the Internet of Things (IoT), it is important to emphasize that banks are also prime targets for cybercriminals. As traditional financial institutions, banks hold large amounts of sensitive information and funds, making them particularly attractive for cyber attacks.
In the modern banking system, information and communication technologies play a crucial role in providing financial services and managing banking operations. However, this growing dependence on computer systems and communication networks makes the banking sector vulnerable to cyber risks and cyber attacks.
Regulation and diversification, essential protections against banking risks
The bankruptcy of two American banks, SVB and Signature Bank, raises legitimate concerns about the risk of contagion in the global banking sector. However, governments and regulators have a crucial role to play in minimizing this risk. Strict regulation and effective supervision of banks help ensure their strength and stability in the face of economic and financial shocks. Furthermore, as a user, diversifying one's holdings and investments can also provide some protection against risks related to a bank's bankruptcy. By diversifying assets and avoiding reliance on a single financial institution, consumers can reduce their exposure to systemic risks.
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