The butterfly effect: How the failure of a small US bank toppled a giant in Switzerland

John Lonsdale, the chair of the Australian Prudential Regulation Authority, talked about the “butterfly effect” as he discussed the current banking crisis on Tuesday. Given that a run on a relatively small bank in California led to the toppling of a global banking giant in Switzerland, it could be said we’ve seen a demonstration of that effect.

The butterfly effect is the idea that relatively small changes in one place – the fluttering of a butterfly’s wings in Brazil is the most commonly used example – can lead to significant consequences elsewhere, like (in Lonsdale’s example) a tornado in Texas.

APRA chairman John Lonsdale at the Australian Financial Review’s banking summit this week.Credit: Natalie Boog

The events of the past few weeks have shown quite graphically how the collapse of a bank with $US209 billion ($312 billion) of assets in the US, the Silicon Valley Bank, can trigger an implosion of a bank with about $US580 billion of assets in Switzerland, Credit Suisse, while igniting runs on other US regional banks and threatening substantial damage to America’s real economy.

Regulators everywhere are scrambling to understand what has happened and how it was allowed to happen in an international banking industry that was subjected to a serious upgrading of regulation and supervision after the 2008 financial crisis.

Lonsdale was in a good position to discuss these matters when he spoke at the Australian Financial Review’s banking summit this week.

The prudential requirements in Australia, where the crisis overseas has barely caused a ripple, provide a template for how to address some of the shortcomings in regulation that the collapse of the Silicon Valley, Signature and Silvergate banks in the US and the forced takeover of Credit Suisse by UBS have exposed.

After the 2008 crisis, APRA adopted a conservative version of the global banking reforms the global financial crisis had induced and then, acting on the recommendations of the David Murray-led financial system inquiry in 2014, strengthened them even further.

The prudential requirements in Australia, where the crisis overseas has barely caused a ripple, provide a template for how to address some of the shortcomings in [global banking] regulation.

As a result, Australian banks hold significantly more capital and more and higher quality liquidity than their international peers. Australia is also the only jurisdiction where banks are forced to increase their capital when rising interest rates generate unrealised losses on their exposures to fixed interest securities such as bonds. The banks also hedge their interest rate risk.

It was the losses Silicon Valley Bank realised when it was forced to sell almost its entire portfolio of available for sale securities that triggered the violent run on its deposits – $US42 billion in a day – that caused it to collapse.

The speed at which the bank failed, and the speed at which contagion from its failure spread – not just within the US banking system, where deposits flowed out of the regional banking sector and into the big banks and money market funds, but also across the Atlantic – is a major lesson from the episode.

It underscored how exposed banking systems are in a digital age, where deposits can be withdrawn and transferred with a few clicks on a mobile phone, and how interconnected and vulnerable the global banking sector is while the traumas of 2008 linger in depositors’ memories.

While Lonsdale had a relatively easy time at the AFR’s summit, US regulators weren’t treated as gently when they appeared before a congressional banking committee in the US Senate in a hearing that again exposed how dysfunctional the US political system is, and how unlikely it is that the obvious responses to the bank failures will be implemented.

No one is arguing against the proposition that the root cause of Silicon Valley’s failure was, as the Federal Reserve Board’s vice-chair for supervision Michael Barr said, a “textbook case of mismanagement”.

The bank didn’t manage the risk of the concentration risk in its deposit base – dominated by tech companies – nor the interest rate risk in its liabilities even though the Fed’s staff had been discussing these risks with the bank since late 2021.

That also says something about the quality of the Fed’s regulation, but the rolling back of some Dodd-Frank banking reforms by the Trump administration in 2019 as part of its war on regulation – the capital and liquidity requirements for banks with less than $US250 billion of assets were lightened, as was their supervision – meant the bank wasn’t subject to the liquidity coverage ratio and net stable funding requirements larger banks have to observe, and it didn’t have to hold capital against any unrealised losses on the securities it held.

Had the deregulationists in the Republican Party and within the Fed – the then vice-chair for supervision Randal Quarles led the charge – got their way, even those US banks of global systemic importance would have seen their regulation weakened.

Barr’s immediate predecessor and Joe Biden’s recently appointed senior economic adviser Lael Brainard was a lone and lonely dissenting voice within the Fed. Her opposition is credited with having a major influence in the failed attempt to deregulate the major US banks.

Proponents of deregulation of banks (the Republicans at Tuesday’s hearing remain opposed to increased regulation) want to generate greater economic growth by encouraging the banks to lend more and accept more risk. In the US, the regional banks lobby and its hold on the conservatives in Congress is powerful.

The regional banks dominate commercial and residential property lending and account for about half non-property-related commercial and consumer lending in the US. The contagion that spread from the collapse of Silicon Valley in particular threatened to infect the core of the US financial system and economy, hence the unwillingness of the regulators to allow the failed banks to fail completely.

The US banks that fell over were, by most definitions, small enough to be allowed to fail, but the threat of contagion meant that even a bank below the cut-off point of $US250 billion of assets that the US used to separate the more intrusively regulated banks from the rest could, and did, cause a threat to systemic and economic stability.

In Switzerland, while Credit Suisse had solid capital and liquidity levels, they weren’t sufficient for the bank to withstand the run that developed as depositors (and hedge funds and short sellers) searched for the most vulnerable of the major banks. With assets equivalent to about 69 per cent of Switzerland’s GDP, it was too big to be allowed to fail.

Now Switzerland will have one dominant bank, holding assets that are more than two-and-a-half times the size of its economy. If UBS were to fail, Switzerland would be devastated, with massive consequences elsewhere.

That’s a conundrum the Swiss regulators are now confronted with. They have to ensure that UBS is incapable of failing, which implies draconian regulation and supervision.

The Credit Suisse experience, moreover, will cause the global regulators and their domestic counterparts to re-think how they should deal with banks that are either of global or domestic systemic importance. The mechanisms for resolving the failure of a bank deemed too big to fail were, as the Swiss authorities have said, shown to be useless at their first real stress test.

Credit Suisse’s total failure and wind-up would have destroyed Switzerland and triggered another global financial crisis.

Regulators are now going to have to rethink their approach to dealing with banks that are so big and complicated that they can’t be allowed to fail. One obvious option, and one the Swiss might exercise in relation to UBS, would be to ensure that they aren’t so big and complicated.

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