“The Silicon Valley Bank case is a wake-up call for Europe’s banking regulation”

The case of the U.S. Silicon Valley Bank (SVB) exposes a serious inconsistency in today’s banking regulation. A SAFE team shows how this flaw can be fixed with small regulatory changes, preventing bank runs

From the perspective of financial economists and legal scholars at the Leibniz Institute for Financial Research SAFE, poor risk management at the SVB with large investments in long-term U.S. sovereign bonds underestimated interest rate risk, fueling fear of losses among depositors. The withdrawal of deposits that then began further fueled loss realizations and, in turn, the withdrawal of additional, unappreciated deposits. The core problem with the SVB case, according to the researchers, is not the long-term investment decisions or poor risk management, but the bank run that followed those decisions.
“The SVB case is a wake-up call as it points to a blind spot in the currently applicable banking regulation that urgently needs to be fixed, also to prevent a repeat of the SVB experience in Europe,” says SAFE Director Florian Heider. The core problem is the fact that today’s regulation creates three classes of bank liabilities, with a clear role assignment for only two: Liability capital (consisting of equity and bail-in debt), deposits with deposit insurance, and deposits without deposit insurance. This third class of deposits is the source of all problems because it is the reason for the run on the bank's assets in an actual or perceived crisis – an aspect that SAFE researchers have stressed in an analysis commissioned by the European Parliament.
Set caps on bail-in-able capital

"The fact that uninsured deposits are also being withdrawn is not in itself a sticking point. However, if this withdrawal spreads quickly before market participants can calmly assess the situation and panic ensues at other banks, that is a problem,” Heider continues. According to the SAFE team, the way out of this situation is to abolish uninsured deposits by extending deposit insurance to all deposits except liable capital, including bail-in debt. “However, abolishing unsecured deposits can minimize the risk of bank runs,” says Tobias Tröger, Director of the Law & Finance research cluster at SAFE.
In addition to a minimum regulatory requirement for the amount of bail-in-able capital, this abolition can be done by setting also its upper limit – “with both ideally matching and the buffer for loss absorption being sufficiently thick. Then there is no reason for a bank run, and at the same time market discipline is maintained and even strengthened,” Tröger adds.
For most large banks, their liabilities consist to a considerable extent of the cash reserves and sales revenues of their corporate customers. These short-term funds are a stability risk for any bank, which must fear that depositors will move their balances to another bank for fear of asset losses. SAFE’s proposed new regulation ends the run risk and, in turn, suggests that the balance sheet portion of liable capital may need to be further expanded, or at least rebalanced. “In this way, the risk of panic-induced bank runs could be largely eliminated,” the researchers explain.

Scientific Contacts:

Prof. Dr. Tobias Tröger
Prof. Dr. Florian Heider