The 2023 Banking Turmoil

Early October, the Basel Committee on Banking Supervision (BCBS) published a report[1] on the 2023 banking turmoil that involved the failure of several US banks as well as Credit Suisse. The report draws lessons for banking regulation and supervision which may ultimately lead to changes in banking regulation as well as supervisory practices. In this article we summarize the main findings of the report[2]. Based on the report’s assessment, the most material consequences for banks, in our view, could be in the following areas:

• Reparameterization of the LCR calculation and/or introduction of additional liquidity metrics
• Inclusion of assets accounted for at amortized cost at their fair value in the determination of regulatory capital
• Implementation of extended disclosure requirements for a bank's interest rate exposure and liquidity position
• More intensive supervision of smaller banks, especially those experiencing fast growth and concentration in specific client segments
• Application of the full Basel III Accord and the Basel IRRBB framework to a larger group of banks

Bank failures and underlying causes

The BCBS report first describes in some detail the events that led to the failure of each of the following banks in the spring of 2023:

• Silicon Valley Bank (SVB)
• Signature Bank of New York (SBNY)
• First Republic Bank (FRB)
• Credit Suisse (CS)

While each failure involved various bank-specific factors, the BCBS report highlights common features (with the relevant banks indicated in brackets).

• Long-term unsustainable business models (all), in part due to remuneration incentives for short-term profits
• Governance and risk management did not keep up with fast growth in recent years (SVB, SBNY, FRC)
• Ineffective oversight of risks by the board and management (all)
• Overreliance on uninsured customer deposits, which are more likely to be withdrawn in a stress situation (SVB, SBNY, FRC)
• Unprecedented speed of deposit withdrawals through online banking (all)
• Investment of short-term deposits in long-term assets without adequate interest-rate hedges (SVB, FRC)
• Failure to assess whether designated assets qualified as eligible collateral for borrowing at the central bank (SVB, SBNY)
• Client concentration risk in specific sectors and on both asset and liability side of the balance sheet (SVB, SBNY, FRC)
• Too much leniency by supervisors to address supervisory findings (SVB, SBNY, CS)
• Incomplete implementation of the Basel Framework: SVB, SBNY and FRB were not subject to the liquidity coverage ratio (LCR) of the Basel III Accord and the BCBS standard on interest rate risk in the banking book (IRRBB)

Of the four failed banks, only Credit Suisse was subject to the LCR requirements of the Basel III Accord, in relation to which the BCBS report includes the following observations:

• A substantial part of the available high quality liquid assets (HQLA) at CS was needed for purposes other than covering deposit outflows under stress, in contrast to the assumptions made in the LCR calculation
• The bank hesitated to make use of the LCR buffer and to access emergency liquidity so as to avoid negative signalling to the market

Although not part of the BCBS report, these observations could lead to modifications to the LCR regulation in the future.

Lessons for supervision

With respect to supervisory practices, the BCBS report identifies various lessons learned and raises a few questions, divided into four main areas:

1. Bank’s business models

• Importance of forward-looking assessment of a bank’s capital and liquidity adequacy because accounting measures (on which regulatory capital and liquidity measures are based) mostly are not forward-looking in nature
• A focus on a bank’s risk-adjusted profitability
• Proactive engagement with ‘outlier banks’, e.g., banks that experienced fast growth and have concentrated funding sources or exposures
• Consideration of the impact of changes in the external environment, such as market conditions (including interest rates) and regulatory changes (including implementation of Basel III)

2. Bank’s governance and risk management

• Board composition, relevant experience and independent challenge of management
• Independence and empowerment of risk management and internal audit functions
• Establishment of an enterprise-wide risk culture and its embedding in corporate and business processes.
• Senior management remuneration incentives

3.Liquidity supervision

• Do the existing metrics (LCR, NSFR) and supervisory review suffice to identify start of material liquidity outflows?
• Should the monitoring frequency of metrics be increased (e.g., weekly for business as usual and daily or even intra-day in times of stress)?
• Monitoring of concentration risks (clients as well as funding sources)
• Are sources of liquidity transferable within the legal entity structure and freely available in times of stress?
• Testing of contingency funding plans

4. Supervisory judgment

• Supplement rules-based regulation with supervisory judgment in order to intervene pro-actively when identifying risks that could threaten the bank’s safety and soundness. However, the report acknowledges that a supervisor may not be able to enforce (pre-emptive) action as long as an institution satisfies all minimum requirements. This will also depend on local legislative and regulatory frameworks

Lessons for regulation

In addition, the BCBS report identifies various potential enhancement to the design and implementation of bank regulation in four main areas:

1. Liquidity standards

• Consideration of daily operational and intra-day liquidity requirements in the LCR, based on the observation that a material part of the HQLA of CS was used for this purpose but this is not taken into account in the determination of the LCR
• Recalibration of deposit outflows in the calculation of LCR and NSFR, based on the observation that actual outflow rates at the failed banks significantly exceeded assumed outflows in the LCR and NSFR calculations
• Introduction of additional liquidity metrics such as a 5-day forward liquidity position, survival period and/or non-risk based liquidity metrics that do not rely on run-off assumptions (similar to the role of the leverage ratio in the capital framework)

2. IRRBB

• Implementation of the Basel standard on IRRBB, which did not apply to the US banks, could have made the interest rate risk exposures transparent and initiated timely action by management or regulatory intervention.
• More granular disclosure, covering for example positions with and without hedging, contractual maturities of banking book positions and modelling assumptions 

3. Definition of regulatory capital

• Reflect unrealised gains and losses on assets that are accounted for at amortised cost (AC) in regulatory capital, analogous to the treatment of assets that are classified as available-for-sale (AFS). This is supported by the observation that unrealised losses on fixed-income assets held at amortised cost, resulting from to the sharp rise in interest rates, was an important driver of the failure of several US banks when these assets were sold to create liquidity and unrealised losses turned into realised losses. The BCBS report includes the following considerations in this respect:
  • If AC assets can be repo-ed to create liquidity instead of being sold, then there is no negative impact on the financial statement
  • Treating unrealised gains and losses on AC assets in the same way as AFS assets will create additional volatility in earnings and capital
  • The determination of HQLA in the LCR regulation requires that assets are measured at no more than market value. However, this does not prevent the negative capital impact described above
• Reconsideration of the role, definition and transparency of additional Tier-1 (AT1) instruments, considering the discussion following the write-off of AT1 instruments as part of the take-over of CS by UBS

4. Application of the Basel framework

• Broadening the application of the full Basel III framework beyond internationally active banks and/or developing complementary approaches to identify risks at domestic banks that could pose a threat to cross-border financial stability. The events in the spring of this year have demonstrated that distress at relatively small banks that are not subject to the (full) Basel III regulation can trigger broader and cross-border systemic concerns and contagion effects.
• Prudent application of the ‘proportionality’ principle to domestic banks, based on the observation that financial distress at such banks can have cross-border financial stability effects
• Harmonization of approaches that aim to ensure that sufficient capital and liquidity is available at individual legal entity level within banking groups

Conclusion

The BCBS report identifies common shortcomings in bank risk management practices and governance at the four banks that failed during the 2023 banking turmoil and summarizes key take-aways for bank supervision and regulation.

The identified shortcomings in bank risk management include gaps in the management of traditional banking risks (interest rate, liquidity and concentration risks), failure to appreciate the interrelation between individual risks, unsustainable business models driven by short-term incentives at the expense of appropriate risk management, poor risk culture, ineffective senior management and board oversight as well as a failure to adequately respond to supervisory feedback and recommendations.

Key take-aways for effective supervision include enforcing prompt action by banks in response to supervisory findings, actively monitoring and assessing potential implications of structural changes to the banking system, and maintaining effective cross-border supervisory cooperation.

Key lessons for regulatory standards include the importance of full and consistent implementation of Basel standards as well as potential enhancements of the Basel III liquidity standards, the regulatory treatment of interest rate risk in the banking book, the treatment of assets that are accounted for at amortised cost within regulatory capital and the role of additional Tier-1 capital instruments.

The BCBS report is intended as a starting point for discussion among banking regulators and supervisors about possible changes to banking regulation and supervisory practices. For those interested in engaging in discussions related to the insights and recommendations in the BCBS report, please feel free to contact Pieter Klaassen.

[1] Report on the 2023 banking turmoil (bis.org) (accessed on October 19, 2023)

[2] Although recognized as relevant in relation to the banking turmoil, the BCBS report explicitly excludes from its consideration the role and design of deposit guarantee schemes, the effectiveness of resolution arrangements, the use and design of central bank lending facilities and FX swap lines, and public support measures in banking crises.