Abstract
The focus of this chapter is on the management of risks leading to banking failures. It examines regulatory responses to bank failures and highlights strategies to prevent such failures. The chapter also introduces emerging risks in the banking sector, including the impacts of climate change, digitisation technology, and cyber threats, underscoring the evolving nature of risk management in financial institutions.
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Notes
- 1.
- 2.
Bank resolution is the process of restructuring a failing bank in a way that safeguards public interests, including the continuity of the bank’s critical functions, financial stability, and minimal costs to taxpayers: https://www.srb.europa.eu/en/content/what-bank-resolution.
- 3.
Let us provide few recent illustrative cases:
i. Bank A: After being declared as failing, its capital instruments were revised and another financial institution acquired the bank (e.g. Banco Popular).
ii. Banks B and C: The Resolution Authority determined that public interest was not at stake for these banks. They were then liquidated as per their insolvency law, with a portion of their operations sold to another bank (e.g. Veneto Banca and Banca Popolare di Vicenza).
iii. Bank D and its subsidiary: Both entities were declared as failing, but the public interest criterion was not satisfied. In such situations, the resolution framework suggests orderly winding down based on applicable law (e.g. ABLV Bank).
- 4.
In a recent article, Rajan and Zingales (2023) suggest that US government decision to cover uninsured deposits at Silicon Valley Bank (SVB) weakens free market discipline: https://www.imf.org/en/Publications/fandd/issues/2023/06/POV-riskless-capitalism-rajan-zingales.
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- 6.
A bank run occurs when customers of a financial institution simultaneously withdraw their deposits due to concerns about the institution’s financial stability. With more people withdrawing their funds, the likelihood of default rises, leading to even more withdrawals. In severe situations, the institution’s reserves might be insufficient to meet the withdrawal demands.
- 7.
In continental Europe, the practice of universal banking developed in the nineteenth century, with institutions such as the Société Générale de Belgique and the Caisse Générale du Commerce et de l’Industrie (founded by Laffitte in France).
- 8.
The Bretton Woods system of fixed exchange rates, which was established in 1944, began to unravel in the early 1960s. The US dollar, which was the anchor currency of the system, became increasingly overvalued due to a combination of factors, including the Vietnam War and President Lyndon Johnson’s Great Society programs. The overvaluation of the dollar led to a growing balance of payments deficit for the United States, as other countries were unwilling to purchase increasingly expensive dollars. In August 1971, US President Richard Nixon announced the ‘temporary’ suspension of the dollar’s convertibility into gold. This marked the end of the Bretton Woods system, and by March 1973, the major currencies had begun to float against each other.
- 9.
See the Box, Diamond-Dybvig Model (1983).
- 10.
The Basel III liquidity framework introduced two required liquidity ratios:
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*
The Liquidity Coverage Ratio (LCR), which requires banks to hold sufficient high-quality liquid assets (HQLA) to cover their total net cash outflows over a 30-day stress period.
$$\displaystyle \begin{aligned} LCR = \frac{\text{HQLA}}{\text{Total net liquidity outflows over 30 days}} \geq 100\% \end{aligned}$$ -
*
The Net Stable Funding Ratio (NSFR), which requires banks to hold sufficient stable funding to exceed the required amount of stable funding over a one-year period of extended stress.
$$\displaystyle \begin{aligned} NSFR = \frac{\text{Available amount stable funding}}{\text{Required amount of stable funding}} \geq 100\% \end{aligned}$$
The LCR and NSFR are designed to ensure that banks have sufficient liquidity and funding to withstand a period of financial stress. The LCR focuses on short-term liquidity, while the NSFR focuses on longer-term funding. The Basel III liquidity framework is an important step towards improving the resilience of the global financial system. By requiring banks to hold more liquid assets and stable funding, the framework helps to reduce the risk of bank runs and financial crises.
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*
- 11.
In the US, FDIC deposit insurance is automatic for any deposit account opened at an FDIC-insured bank. The standard insurance amount is $250,000 per depositor, per FDIC-insured bank, for each account ownership category.
- 12.
- 13.
See for instance the run on the FTX cryptocurrency exchange in the late-2022: https://www.wsj.com/articles/crypto-has-reinvented-bank-runs-11668019310.
- 14.
At the average bank, that figure is around one-quarter.
- 15.
For an excellent review of the events: https://www.stlouisfed.org/publications/regional-economist/2023/may/interest-rate-risk-bank-runs.
- 16.
- 17.
- 18.
- 19.
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- 21.
Among the most important initiatives: At the worldwide level, the Paris Agreement signed in December 2015 by 195 nations to keep the rise in mean global temperature well below 2 \({ }^{\circ }\)C above pre-industrial levels and ratified during the 26th Conference of the Parties (https://ukcop26.org/uk-presidency/what-is-a-cop/). At the European level, the European Central Bank (ECB) published its ‘Guide on climate-related and environmental risks’ in 2020. It sets out the ECB supervisory expectations for banks’ risk management and disclosure in this domain. This guide establishes a clear framework for European banks to accurately measure, mitigate, and disclose climate-related and environmental risks. (https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.202011finalguideonclimate-relatedandenvironmentalrisks~58213f6564.en.pdf). In addition, the ECB has adopted a climate agenda and started to carry out climate-stress tests in 2022, designed to prepare banks for both upcoming regulatory changes and climate related-risks, most notably transition and physical risks (https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.202212_ECBreport_on_good_practices_for_CST~539227e0c1.en.pdf).
- 22.
- 23.
- 24.
- 25.
- 26.
For instance, the pressure on traditional banks’ profit margins may necessitate risk-taking.
- 27.
More recently, however, interest rate increases by global central banks to contain the biggest inflation outbreak in four decades generated strains for banks.
- 28.
Cyber risk is commonly referred to any risk of financial loss, disruption, or damage to the reputation of an organisation resulting from the failure of its information technology systems.
- 29.
See Risk.net, ‘Top 10 operational risks for 2018’, as well as for 2019, 2020 and 2021.
- 30.
- 31.
Please see list and details on Appendix 1 in the NIST Framework Version 1.1:https://doi.org/10.6028/NIST.CSWP.04162018.
- 32.
Officially designated as Regulation (EU) 2022/2554.
- 33.
Mentioned in Article 2(1), points (a) to (d).
- 34.
- 35.
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Abidi, N., Buchetti, B., Crosetti, S., Miquel-Flores, I. (2024). Risk Management and Banking Failures. In: Why Do Banks Fail and What to Do About It. Contributions to Finance and Accounting. Springer, Cham. https://doi.org/10.1007/978-3-031-52311-3_2
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