2023 Bank Failures, Preliminary lessons learnt for resolution

After completing this reading, you should be able to:

• Evaluate the Credit Suisse case and its implications for the international resolution framework.
• Evaluate the US bank failures of 2023 and their implications for the international resolution framework.
• Identify and describe the strengths and weaknesses of the resolution framework as demonstrated by Credit Suisse case and the US bank failures of 2023.
• Describe the uncovered issues for bank resolution that require further studies and development for future improvements on the implementation of the international resolution framework.

The Credit Suisse Case and its Implications for the International Resolution Framework

Background on the Credit Suisse Case

Credit Suisse, with a history stretching back to 1856, found itself in one of the most tumultuous periods in its existence in 2023. The bank had been battling a series of setbacks that significantly eroded its reputation and financial stability. These included high-profile scandals like the collapse of Archegos Capital Management, which resulted in billions in losses, and the Greensill Capital affair, where client funds were locked. The bank’s strategy to expand into high-risk investment banking without adequate risk controls had further compounded its troubles, leading to management instability and strategic misdirection.

The situation escalated in 2022 when liquidity stress became evident, particularly in October, with massive client withdrawals signaling a profound crisis of confidence. This was further aggravated in March 2023 when Credit Suisse announced “material weaknesses” in its financial reporting controls, sparking a drastic drop in its share price by nearly 30% in a single day. This disclosure, amidst a global backdrop of banking sector panic following the collapse of Silicon Valley Bank, led to an alarming acceleration in deposit withdrawals.

The Swiss National Bank (SNB) responded by offering an emergency liquidity facility of up to 50 billion Swiss Francs, aiming to stabilize Credit Suisse’s operations. However, this intervention alone was insufficient to quell the crisis. The Swiss Financial Market Supervisory Authority (FINMA) then engaged in intensive discussions to explore resolution options. Despite having prepared for a resolution, including conducting valuations for a bail-in scenario that would have left Credit Suisse with a robust Common Equity Tier 1 (CET1) ratio, the Swiss authorities opted for a different route due to doubts about restoring confidence through traditional resolution methods.

Instead, a commercial transaction was facilitated with UBS. On March 19, 2023, UBS acquired Credit Suisse for roughly 3 billion Swiss Francs, a deal heavily supported by public guarantees. This included a public liquidity backstop, a second-loss guarantee from the Swiss government, and the unprecedented write-down of Credit Suisse’s Additional Tier 1 (AT1) bonds. Such measures were taken to avoid a formal resolution process, which was deemed less effective at that moment for addressing the widespread lack of confidence. The Swiss government’s commitment to cover up to 9 billion Swiss Francs in potential losses highlighted the extraordinary nature of the intervention to safeguard financial stability.

This culmination of events not only showcased the depth of Credit Suisse’s crisis but also highlighted the complexities and decisions involved in managing the resolution or stabilization of a Global Systemically Important Bank (G-SIB) under international scrutiny and amidst significant market and confidence challenges.

Implications for the International Resolution Framework

The resolution of Credit Suisse in 2023, leading to its acquisition by UBS, provided a complex case study for evaluating the international resolution framework. Despite the framework’s preparations, the Swiss authorities chose a commercial transaction over a formal resolution, highlighting several key implications:

• Public liquidity backstop: The case underscored the critical need for an effective public sector liquidity backstop. Credit Suisse’s crisis was managed with ample liquidity facilities, including a public liquidity backstop and a second-loss guarantee from the Swiss government, which were pivotal in supporting financial stability. This intervention outside of formal resolution processes points to the necessity of having such mechanisms in place as a last resort to mitigate systemic risks.
• Operational readiness: The FSB review indicates that both banks and resolution authorities must enhance their operational readiness. This includes not only having resolution plans but also ensuring these plans are actionable. For Credit Suisse, despite the preparatory work like conducting two valuations for bail-in in November 2022 and March 2023, which projected a strong CET1 ratio post-bail-in, the Swiss authorities had reservations about executing this strategy due to ongoing crises of confidence.
• Cross-border resolution challenges: The collaboration within the Crisis Management Group (CMG), which included key home and host authorities like the Bank of England, Federal Reserve, FDIC, and SEC, was significant. Yet, the execution of bail-in across borders revealed ongoing legal issues that need resolution. The case emphasizes the importance of addressing these legal complexities to ensure seamless cross-border resolution processes.
• Bail-in and market impact: The write-down of Credit Suisse’s Additional Tier 1 (AT1) bonds without a full bail-in process raised questions about the impact of resolution actions on financial markets. The framework needs to better operationalize various resolution options, including transfer and sale of business tools, potentially in combination with bail-in, to understand and mitigate market disruptions.
• Simulation and decision-making: The need for regular testing and simulation of resolution scenarios was highlighted, particularly in terms of decision-making and execution across both domestic and international jurisdictions. The Credit Suisse case showed there is room for improvement in how authorities communicate and coordinate, suggesting these efforts should extend beyond the core CMG.
• Resolution vs. commercial solution: The Swiss decision to opt for a commercial transaction, despite the availability of a resolution strategy, indicates that while the framework provides viable alternatives, the choice of action can be influenced by perceived effectiveness in maintaining financial stability and confidence. This case reaffirms the framework’s robustness by providing options, yet it also calls for deeper analysis on when and how to deploy these options effectively.

The US Bank Failures of 2023 and Their Implications for the International Resolution Framework

Background of the US Bank Failures in 2023

In the United States, the banking sector experienced significant turmoil in early 2023 with the failures of Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank. These events marked one of the largest bank failures in U.S. history since the Global Financial Crisis, highlighting vulnerabilities and challenges within the existing resolution frameworks:

• Silicon Valley Bank (SVB): SVB, primarily serving the venture capital industry, failed due to unrealized losses from concentrated bond exposures, liquidity mismatches, and a large proportion of uninsured deposits. A rapid deposit run was triggered after SVB announced significant losses from selling securities and attempted to raise capital, leading to its closure by the California Department of Financial Protection and Innovation (CADFPI) on March 10, 2023, with the FDIC appointed as receiver.
• Signature Bank: Following SVB’s failure, Signature Bank, which had significant exposure to the cryptocurrency sector and also relied heavily on uninsured deposits, faced a similar deposit run. It was closed by the New York State Department of Financial Services (NYDFS) on March 12, 2023, with the FDIC again appointed as receiver due to concerns about its ability to meet deposit obligations.
• First Republic Bank: The fallout from SVB and Signature Bank led to loss of confidence in First Republic Bank, which had a high percentage of uninsured deposits and was affected by market contagion. It was closed by CADFPI on May 1, 2023, and taken over by JPMorgan Chase under a purchase and assumption agreement facilitated by the FDIC.

Implications for the International Resolution Framework

The U.S. bank failures brought to light several implications for the international resolution framework as detailed in the FSB report:

• Systemic significance of non-G-SIBs: These cases demonstrated that banks not officially designated as G-SIBs or D-SIBs can still have systemic implications upon failure, suggesting a broader scope for resolution planning to include banks based on their potential systemic impact rather than just size or complexity.
• Uninsured deposits and liquidity risks: Banks heavily reliant on uninsured deposits are particularly vulnerable to rapid deposit withdrawals, especially when exacerbated by social media and digital banking technologies. This vulnerability necessitates a reevaluation of liquidity management and the role of deposit insurance in maintaining stability.
• Resolution planning for non-G-SIBs: There was a lack of detailed resolution planning for these banks, which had only recently or were about to come under more stringent resolution planning requirements. This suggests a need for enhanced resolution planning capabilities, including the ability to quickly assess and market an institution in distress, and to operationalize staff retention plans.
• Loss-absorbing capacity requirements: The absence of sufficient loss-absorbing capacity in these banks highlighted the need for such requirements to be extended beyond just G-SIBs. This capacity would act as a buffer, potentially reducing the need for systemic risk exceptions and protecting both depositors and the financial system.
• Speed of bank runs: The rapid nature of these bank runs, facilitated by digital tools and social media, underscored the need for resolution authorities to be prepared for swift action. This involves not only having the tools but also the communication strategies to manage depositor panic.
• Role of deposit insurance: The decision to invoke the systemic risk exception to cover all depositors (insured and uninsured) raised questions about moral hazard and the adequacy of current deposit insurance coverage. The interaction between deposit insurance, resolution mechanisms, and loss-absorbing capacity needs careful consideration to balance financial stability with market discipline.
• Flexibility in resolution implementation: The cases showed that while a preferred resolution strategy is essential, authorities must retain flexibility to adapt to the unique circumstances of each failure, ensuring that resolution strategies can be adjusted or combined to meet the objectives of financial stability and depositor protection.

The Strengths and Weaknesses of the Resolution Framework as Demonstrated By the Credit Suisse Case and the US Bank Failures of 2023

Strengths

From the Credit Suisse Case:

• Total Loss-Absorbing Capacity (TLAC): The presence of sufficient TLAC was a pivotal strength, allowing for the contemplation of a bail-in strategy. This meant there was a potential mechanism to absorb losses without resorting to taxpayer funds, demonstrating the effectiveness of the TLAC standard in providing a cushion against bank failure.
• Resolution planning: Over a decade of planning for G-SIBs like Credit Suisse ensured that Swiss authorities had a detailed resolution strategy ready. This included legal entity simplification, liquidity and valuation reporting, and operational continuity plans, which were instrumental in managing the crisis even if a formal resolution was not executed.
• Cross-border cooperation: The CMG, established for G-SIBs, played a crucial role in fostering cooperation between Swiss authorities and key international regulators. This cooperation extended to sharing information, preparing for potential bail-in execution, and ensuring that host authorities understood and were prepared to support Swiss resolution measures if necessary.
• Preparedness for multiple scenarios: The Swiss authorities had prepared for various resolution scenarios, including a detailed plan for bail-in, which provided them with strategic flexibility. This preparedness showed that the framework could handle complex resolutions, even if alternative solutions were chosen in the end.

From the US Bank Failures:

• Ex ante contingency planning: The FDIC’s proactive planning, with a focus on bridge bank operations, allowed for swift action in setting up bridge banks for SVB and Signature Bank. This planning included regular exercises, which ensured that staff were familiar with the process, enhancing the efficiency and effectiveness of the resolution.
• Cross-border engagement: Despite these banks not being G-SIBs, the FDIC’s use of CMG contacts for international outreach underscored the value of established relationships in managing the global aspects of resolution, even for institutions with significant international operations.
• Resolution tools implementation: The use of bridge banks, alongside the systemic risk exception for SVB and Signature Bank, demonstrated that the framework has the capability to manage bank failures without direct taxpayer intervention, with losses absorbed by shareholders and unsecured creditors, thus adhering to the principles of resolution.

Weaknesses

From the Credit Suisse Case:

• Strategic optionality: The choice to facilitate a commercial transaction over formal resolution highlighted a potential shortfall in the framework’s strategic tools. In this case, the Swiss authorities perceived that bail-in might not sufficiently restore market confidence under the prevailing conditions, indicating a need for more adaptable resolution strategies.
• Public sector backstop: The reliance on significant public sector liquidity support outside of the formal resolution process pointed to a gap in the framework’s ability to provide adequate liquidity backstops within resolution mechanisms, which are crucial for restoring market confidence.
• Legal and operational challenges: Even with extensive preparation, the near execution of bail-in brought to light ongoing legal complexities, particularly concerning cross-border bail-ins. Issues like compliance with securities laws in different jurisdictions could impede or delay resolution actions.
• Restoring market confidence: The case underscored that implementing resolution tools alone might not be enough to rebuild market trust. Effective post-resolution communication and restructuring plans are essential, which if not well-prepared, can leave the framework less effective in achieving its objectives.

From the US Bank Failures:

• Systemic significance assessment: The systemic impact of non-G-SIBs like SVB, Signature, and First Republic Bank suggested that the current criteria for identifying systemic institutions might need broadening to include banks based on their actual impact rather than just size or complexity.
• Speed of bank runs: The unprecedented speed of deposit withdrawals, driven by digital banking and social media, revealed a weakness in the framework’s agility to counteract rapid liquidity outflows, emphasizing the need for faster resolution execution capabilities.
• Uninsured deposits concentration: The heavy reliance on uninsured deposits by these banks highlighted vulnerabilities in liquidity management. This scenario questions whether the resolution framework adequately addresses banks with such funding models, potentially leading to systemic risk exceptions and moral hazard concerns.
• Resolution planning for Non-G-SIBs: The limited resolution planning for these banks before their failure indicated a gap in applying resolution requirements to banks that, while not formally systemic, can cause significant market disruption.
• Loss-absorbing capacity: The lack of mandated long-term debt or other loss-absorbing capacities for these banks showed a potential weakness in the framework’s design for smaller or regional banks, where such instruments could mitigate or prevent the need for resolution actions.

These insights from both the Credit Suisse and U.S. cases illuminate the areas where the international resolution framework has shown resilience and where there are clear opportunities for enhancement, ensuring it remains effective in a rapidly evolving financial landscape.

Issues Requiring Further Study and Development

1. Effective Public Sector Backstop Funding Mechanisms:

The recent bank failures, particularly in Switzerland and the US, highlighted the need for robust public sector backstop funding mechanisms. These mechanisms should be designed to support resolution and restore market confidence without encouraging moral hazard. Key issues include:

• • Ensuring the adequacy of existing public backstops across jurisdictions for various failure scenarios.
  • Exploring the design features like size, collateral requirements, duration, and safeguards that might present barriers to effective resolution.
  • Assessing the operational readiness of banks to access these backstops as a last resort.

2. Choice of Resolution Strategies and Optionality of Resolution Tools:

The frameworks should allow for flexibility in choosing resolution strategies, recognizing that not all crises can be addressed with a one-size-fits-all approach:

• • Investigating the effectiveness of bail-in in liquidity-driven failures and the potential for combining it with other resolution strategies like asset transfers or business sales.
  • Discussing how to maintain flexibility without compromising the preparedness for executing the preferred strategy, including considering multiple scenarios in resolution planning.

3. Communications, Coordination, and Speed of Bank Runs:

The rapid pace of bank runs due to digital innovation necessitates improvements in:

• • Crisis communications to restore depositor and market confidence, both in general and specific to crisis situations, including how central banks communicate liquidity provision.
  • Coordination with foreign authorities beyond just CMG members, particularly in non-CMG jurisdictions where indirect impacts might occur.
  • Enhancing ex ante communications to educate markets about resolution processes to reduce uncertainty and litigation risks.
  • Strategies to counter the accelerated speed of bank runs, ensuring resolution authorities can act swiftly with adequate communication plans.

4. Operationalization of Bail-in:

Cross-border bail-ins present legal complexities that need resolution:

• • Ensuring bail-in powers are enforceable under all applicable laws, including those of TLAC instrument holders.
  • Identifying and preparing for compliance with applicable securities laws, exchange requirements, and potential exemptions, especially in multi-jurisdictional contexts.
  • Enhancing cross-border coordination to manage legal challenges and ensure the effectiveness of bail-in without disrupting investor confidence.

5. Post-stabilization Restructuring:

The transition from resolution to a stable, credible business model requires:

• • Pre-planning for restructuring to ensure a clear message can be communicated to the market immediately after resolution, outlining the path to viability.
  • Exploring practices for preparing a restructuring plan that can effectively restore market confidence in the resolved bank’s business model.

6. Resolution of Banks That Could Be Systemic in Failure:
   The scope of resolution planning needs to be expanded to consider banks beyond just G-SIBs:

• • Assessing what constitutes systemic significance or criticality, including factors like deposit concentration, sectoral exposure, and potential contagion risks.
  • Determining appropriate levels of resolution preparedness for these banks, considering proportionality and the benefits of loss-absorbing capacity requirements.

7. Uninsured Deposits and the Role of Deposit Insurance in Resolution:
   The interaction between deposit insurance and resolution mechanisms calls for:

• • A review of deposit insurance coverage levels to mitigate financial stability risks from uninsured deposits, while addressing moral hazard.
  • Discussing how loss-absorbing capacity can provide protection for uninsured depositors, reducing the need for systemic risk exceptions.
  • Considering the role of deposit insurance in ensuring prompt reimbursement and continuity of access to banking services, enhancing the credibility of depositor protection.

Question

One of the key lessons learned from the US bank failures of 2023 pertains to the scope of resolution planning. What specific aspect of this planning was highlighted as needing further attention?

1. A) The need for more frequent stress tests for large banks.
2. B) The potential systemic impact of institutions not designated as G-SIBs or D-SIBs.
3. C) The importance of stricter capital requirements for all banks.
4. D) The requirement for all banks to hold a minimum amount of liquid assets.

Correct Answer: B

The failures of SVB, Signature, and First Republic showed that institutions that are not considered systemically important under traditional metrics (size, interconnectedness, complexity) can still have significant destabilizing effects, particularly due to factors like concentrated business models (SVB and tech startups), reliance on uninsured deposits, and rapid deposit withdrawals. This highlighted the need to broaden the scope of resolution planning beyond just G-SIBs and D-SIBs to include institutions that could become systemically important in failure.

A is incorrect. While stress testing is a critical tool for assessing resilience, the 2023 bank failures highlighted vulnerabilities outside the scope of traditional stress tests, particularly among mid-sized institutions.

C is incorrect. While capital requirements are essential, the main issue was not inadequate capital levels but rather liquidity crises and the speed of deposit withdrawals, particularly at mid-sized banks.

D is incorrect.  Banks are already subject to liquidity requirements under frameworks such as the Liquidity Coverage Ratio (LCR). The highlighted need was to address the systemic importance of certain mid-sized institutions and improve planning for their resolution.