financial crisis

Restoring Confidence in the US Banking System

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Considering the 2008 financial crisis, how can the US restore confidence in the US banking system?

 

The Global Financial Crisis of 2007-2009 had a profound effect on US and global financial markets and destroyed confidence in the banking systems in the US and other major economies. It caused a global economic recession and resulted in massive bailouts of US and other financial systems, and the global economy is only just recovering from the effects of this crisis.

 

The crisis highlighted weaknesses, in the US banking system, which will require a combination of different measures in order to be addressed. Among the myriad issues highlighted by the crisis the biggest issue is, arguably, the need to address the systemic risks inherent in the banking system.

 

The systemic risks inherent in the banking system have been widely discussed in the aftermath of the crisis. Systemic risk arises in the banking system because of the potential for the failure of one bank or financial institution to affect other banks or financial institutions to such an extent that those other banks also face financial problems or even failure as well. Banks are connected to each other through the payments system and the financial system, and if a bank faces difficulty meeting its obligations to other banks this could, in turn force those other banks to face difficulty fulfilling their own obligations thus triggering a chain of bank failures. The risk posed by this ‘interconnectedness’ of banks to each other is currently the biggest headache for bank regulators around the world.

 

Restoring confidence in the US banking system requires properly addressing this systemic risk. There are two aspects to this. The first is ensuring that banks are well capitalized and well run so that they are resilient and do not run into financial problems. The second is ensuring that when banks run into financial problems there are efficient, well laid out plans for dealing with those banks so that the problems do not spill over to other banks or the wider banking system.

 

Ensuring that banks are well capitalized and well run requires the type of comprehensive, far-reaching regulation that can be found in the Obama administration’s Dodd Frank Act 2010. The legislation improves the overall structure of bank supervision in the US, closes loopholes in banking regulation, protects consumers and provides the US authorities with the tools they need to manage future financial crises. Despite this progress that has been made there remains more to be done to restore confidence in the US banking system. The banks themselves are already failing to live up to the new standards set by the regulation- in 2015 some of the biggest US banks struggled to pass the Federal Reserve’s ‘stress tests’. Goldman Sachs Group Inc, Morgan Stanley and J.P Morgan Chase & Co had to make adjustments to their capital buffers, while Bank of America Corp had to submit a revised plan, addressing its shortcomings, to the Federal Reserve.

Stress tests are used by regulators to determine whether a bank has enough capital to withstand the impact of unfavorable or adverse scenarios such as a deterioration in global economic conditions. The fact that some of the largest US banks are struggling to pass stress tests is worrying and should serve as a wake-up call to the banking industry to put its house in order.

 

Ensuring that there are efficient plans for dealing with banks that do run into financial problems has become another top priority for regulators in the aftermath of the crisis. It is unrealistic to expect that banks will never face financial problems and bank failures can always be prevented. The more responsible view is that there will be some banks that run into financial problems and there has to be a way to deal with such banks so as to avoid the problem spreading to other banks and thereby adversely affecting the banking system. This is the reason regulators have embraced the idea of Recovery and Resolution plans (also referred to as ‘living wills’) for banks.

 

Dealing with failing banks in an efficient manner can also help to avoid bank bailouts whereby taxpayers’ money is used to rescue struggling banks. Bank bailouts encourage what economists refer to as ‘moral hazard’, a situation where one person or institution takes more risks because it knows someone else will bear the costs of those risks. There are, however, signs that the banking industry is not taking the issue of recovery and resolution as seriously as the regulators- the Recovery and Resolution plans of five of the largest US banks were rejected by the Federal Reserve and the FDIC because the regulators were not convinced they would ensure an orderly and efficient resolution of those banks if they faced financial difficulties. J.P Morgan Chase & Co, Wells Fargo & Co, Bank of America Corp, State Street Corp and Bank of New York Mellon Corp have been given until October 1 this year to re-submit revised plans that convince the regulators that their Recovery & Resolution would not require tax-payer funded bailouts.

 

Tackling systemic risk is the key to restoring confidence in the US banking system, and this involves all stakeholders playing their part. The regulators have increased the level of supervision of the banking industry after the crisis and the onus is now on the banking industry to show that it recognizes, and is prepared to deal with, the systemic risks in the banking system. If the banking industry fails to get its act together then there is a greater likelihood that there will be another major financial crisis. It is, therefore, important for the banks to ensure that, at a minimum, they are complying with both the spirit and the letter of the new regulatory rules.