Global banking crisis leaves a trail of unanswered questions

While both the 2008 Global Financial Crisis and the 2023 banking crisis have a weak financial system at its centre, the challenges posed are different

‘May you live in interesting times’ is an English expression thought to be the translation of a Chinese curse. Whatever its origins, it aptly reflects the global economy and financial markets.

For the last decade and a half we have had one shock after the other: the Global Financial Crisis (2008), the Europe debt crisis (2009), Brexit (2016), Covid-19 (2020), and the current Russia-Ukraine war. The latest addition to the list is the failures of three regional banks in the United States and a major global bank in Switzerland.

The 2023 banking crisis yet again brings the spotlight to the health of banking systems and banking regulation across the world. The 2008 crisis led to many lessons, which were new for the developed West. Rakesh Mohan, the former Deputy Governor of the Reserve Bank of India (RBI), termed it as the North Atlantic Financial Crisis.

Stop The Spread

The 2008 crisis taught us three lessons. The first was that a financial crisis can lead to a larger macroeconomic crisis, and even a recession.

The 2008 crisis started with the failure of Lehman Brothers, which lead to the freezing of the financial markets. This, in turn, threatened other large financial firms. The US unemployment rates jumped, followed by a decline in GDP growth, eventually resulting in a major recession in the US.

Policymakers understood that one needs to quickly resolve the failed financial firm(s). Other parts of the financial system need to be ring-fenced, to prevent the crisis spreading. In such situations, central banks must provide liquidity because a lack of liquidity must not translate into a solvency problem.

The Good And The Bad

The second lesson is that financial risks can spread much faster than anticipated. The 2008 crisis started in the US and quickly spread to other global financial markets. The emerging markets recovered faster as their less developed financial systems did not have interlinkages with the US system. However, in Europe’s developed economies, the crisis not only created multiple problems, but also threatened the Euro currency project.

Policymakers realised that financial globalisation has its benefits, but it also has its risks. One must actively monitor global financial developments, and build buffers and reserves to safeguard against global shocks.

Price Stability, Financial Stability

The third lesson was that apart from price stability, central banks need to focus on financial stability. Before the 2008 crisis, the economic consensus was that central banks need to just focus on price stability. In the period preceding the crisis, prices were broadly stable, but we still had a financial crisis. After 2008, the consensus is that price stability is necessary, but not a sufficient condition for macroeconomic stability. Financial stability is equally important.

This led to large-scale reforms. Central banks started to focus on financial risks, sharpened regulations, pushed banks to raise capital, identified non-banking risks, among others.

Have We Learnt Our Lessons?

Fifteen years later, we have another crisis which has also started from the US, and threatens to spread across the world. Have we acted on the three lessons learnt from 2008?

Based on the first lesson learnt, no sooner did the Silicon Valley Bank crisis become clear than the Federal Deposit Insurance Corporation (FDIC) became the receiver of the failed banks. A joint statement from the US Treasury, the FDIC, and the US Federal Reserve assured the depositors and larger financial market participants that this crisis will be contained. The Federal Reserve also announced that it would provide liquidity to all the banks. Across the Atlantic, the Swiss policymakers were rather slow to act, as they waited too long before coming out with a plan for Credit Suisse.

On the second lesson learnt, authorities were a bit slow to react, and it was only after the debacle of Credit Suisse did central banks of advanced economies issue a joint press release assuring markets of providing liquidity in US Dollars.

As far as the third lesson, there is a long way to go. The current crisis has thrown up new challenges. If in 2008 it was easy money that fuelled the housing bubble, in 2023 it is the tight monetary policies which have led to the decline in bond prices leading to the current crisis. If in 2008 we saw higher lending in housing, in 2023 it is higher investments in securities. The 2008 crisis was driven by banks borrowing on repo securities, whereas 2023 crisis is due to banks being funded by uninsured deposits. The 2008 crisis was mainly a failure of ‘Too Big To Fail’ banks, in 2023 it is the failure of large regional US banks.

More Unanswered Questions

Where does this place the Indian banking system? The 2008 crisis did not impact the Indian banking system adversely, barring the ICICI Bank. However, since 2013 onwards, India faced a large-scale banking crises: from bank frauds to rising non-performing assets, and governance issues. Initially affecting Public Sector Banks, it soon engulfed private banks, co-operative banks, non-banking finance companies (NBFCs), and housing finance companies (HFCs). These led to several reforms in India’s banking system.

These crises led the RBI to further strengthen its regulation and supervision. Thus, the Indian banking sector entered the pandemic and the post-pandemic phase in a relatively better state. That said, as trust in the financial sector evaporates quickly, the RBI needs to keep constant vigil on global developments.

The 2023 banking crisis throws at us several unanswered questions: Why is it that the world’s largest economy is yet again found to have a fragile financial system? How did failure of regional banks lead to concerns for the global banking system? While digitalisation has helped banking, it also leads to quicker bank failures as depositors can withdraw funds in a few clicks. How do we balance the yin and yang of digitalisation? These questions (and many more as we learn) will continue to draw researchers and policymakers to seek answers.

(Amol Agrawal is an economist teaching at Ahmedabad University.)