Stronger Banks, But Bank Runs Are Still a Possibility
The European banking sector has weathered various shocks in the last years, showing significant resilience. Faced with the Covid-19 pandemic, the Russian invasion of Ukraine and the sudden inflation surge, European banks have continued supporting the real economy while at the same time strengthening their capital and liquidity levels, as shown also by the results of the latest stress tests.Such resilience results, at least partly, from the wide regulatory package implemented in the aftermath of the global financial crisis together with the stricter supervision enforced through the creation of the Single Supervisory Mechanism. The regulatory efforts contained in the so-called Basel III reforms have concentrated on strengthening bank capital levels through, for example, a reduction of non-performing loans or the introduction of new prudential buffers.
The last year has, however, marked a structural break in the macroeconomic environment and banking landscape. For the first time after decades of low interest rates, banks are confronted with tightening monetary policy and a consequent sudden rapid increase of interest rates. While higher rates have contributed to improve bank profitability via higher net interest margins, they have also raised concerns in relation to the management of interest rate risk and bank liquidity positions.
The failure of Silicon Valley Bank and other mid-sized banks in spring 2023 has reminded us of the importance of properly managing the maturity mismatch between long-term assets and demandable liabilities. The massive and fast outflow of deposits has shown the potential abrupt effects of bank runs in a modern world of digital banking and has raised the attention on the appropriateness of the liquidity regulation introduced with the Basel III rules.
The accounting and regulatory treatment of the security investments in the banking book has raised the attention to how banks manage and hedge interest rate risk within their asset liability management, and on the appropriateness of the current Pillar 2 treatment of such risk. The last stress tests conducted by the European Banking Authority and the European Central Bank have however shown that the issue of potential "unrealized losses" in the banking book is less worrisome in Europe than in the US, despite deserving close monitoring going forward. The initial disruptions in the funding costs of European banks following the failure of Credit Suisse have been reabsorbed and market conditions are almost the same as in the pre-crisis period.
The new monetary environment is also creating a new structural trend in bank deposits. Both US and European banks have experienced a reduction in their total deposit volumes in the last year, although with an apparent stabilization in the second quarter of 2023. At the same time, the pricing of deposits is changing rapidly, with substantial heterogeneity across banks and countries depending on the structure of the banking sector, the type of clients and deposits and the alternative assets available (e.g. government bonds).
Corporates are either using their cash deposited at banks in an attempt to avoid taking new loans at higher costs or are demanding higher remuneration on the deposits left in current accounts. In some countries, retail clients are switching to term deposits paying higher rates (e.g. in Germany and Austria) or investing the cash in their deposits in alternative assets such as short-term government bonds (e.g. Belgium). A few countries (e.g. Spain, Portugal, Italy and Ireland) are currently outliers in that deposits seem to be rather sticky in terms of pricing. Yet, even in those countries, a few banks are starting to "break" the equilibrium and offer higher rates in an attempt to attract new clients.
The future development of deposit funding deserves close attention. Deposits are the most important source of financing for banks and it is by far still the cheapest. Higher deposit rates entail lower returns but leave liquidity available in the bank. Lower deposit volumes shrink the possibility for banks to continue lending and thus have broader implications for banks' ability to support the economy going forward.