Science has strengthened the banks – but how long will the stability last?

Twelve years ago, an unusual study used insights from ecology and infectious disease research to show that the failure of “superspreader” banks would shake the entire financial system.¹ The work, titled “Systemic Risks in Banking Ecosystems,” demonstrates that banks are interconnected like living things. A series of high-profile bank failures in the past few weeks have renewed fears that the financial ecosystem is at risk.

Study co-author Andrew Haldane, former chief economist at the Bank of England, said the research played a key role in persuading banking regulators to pay attention to the stability of the banking system after the 2007-2008 global financial crisis, which devastated banks and savings as a result. He produced the study with mathematical ecologist Robert May, drawing on May’s long-standing research on diversity and stability in ecosystems.

According to the US government’s Federal Deposit Insurance Corporation (FDIC), more than 400 banks closed in the United States alone between 2008 and 2012 — compared to just 10 in the 5 years before the crisis. The U.S. government has paid about $500 billion to keep the remaining banks viable, according to a 2019 study by Deborah Lucas, who researches financial policy at the Cambridge-based MIT.²

“The penny dropped during the crisis,” says Haldane. It took that event, he says, to open the minds of financial regulators to the idea that the risk of an individual bank failing should really be reflected in the damage it might do to the system; and it depends on how deeply the bank is connected to other parts of the financial system.

Haldane’s latest comments follow a string of high-profile bank failures in the past month, which have renewed fears of financial instability.

On March 10, Santa Clara, California-based Silicon Valley Bank (SVB), which lent money primarily to tech startups, saw depositors withdraw US$42 billion. California’s state regulator shut down the bank and its UK arm was subsequently absorbed by multinational bank HSBC for £1 (US$1.24). Two days later, New York-based Signature Bank also closed. A week later, regulatory agencies in Switzerland approved the acquisition of Credit Suisse by its rival bank UBS, both based in Zurich, Switzerland.

According to Stefano Battiston, who studies systemic risks in financial networks at the University of Zurich, Switzerland, the roots of SVB’s failure are the rapid increases in interest rates that have been observed globally. Interest rates have been low for several decades and many banks have put money into seemingly safe interest-bearing bonds. But as interest rates skyrocketed, those bonds quickly lost value. According to one estimate, US banks held more than $620 billion in unrealized loss assets due to rising interest rates by the end of 2022.

On March 8, SVB announced it needed to raise $2.25 billion to cover such an asset shortfall. Sensing trouble, bank customers rushed to withdraw their deposits, creating a bank run. Its stock price collapsed and 48 hours later it was shut down by regulators, the fastest bank shutdown in US banking history. While SVB was an emergency, other banks are at risk, Battiston says, especially those more closely related to other banks.

The speed of SVB’s collapse was also influenced by frenzied social media activity, according to a study published April 6 in the Social Science Research Network preprint repository by Stefan Bales and Hans-Peter Burghoff, who both study banking at the University of Hohenheim , Germany. The researchers looked at tweets and Google search data from the days when SVB was calling for more capital until its eventual closure. They found that the most intense period of activity on Twitter corresponded with the crash in the bank’s share price on March 9.³

So far, however, these incidents have not caused an infection. That doesn’t mean it can’t happen, the researchers say, but central banks and regulators have better control over the banking system as a whole than they did in 2008.

“I think it’s too early to say we’ve prevented a banking crisis,” says Battiston. “But there has been real progress since 2008. Authorities are now taking seriously the idea that the financial system is a complex web that needs careful monitoring,” he adds. “Now there is also a system to monitor the assets of the banks at different levels.”

One such measure is a system of banking regulations known as Basel III, adopted after 2010. “These rules reflect a very different model of regulation,” Haldane notes, “in which larger, more connected banks are forced to hold more large buffers of regulatory capital.” Basel III, he says, also identifies a list of systemically important banks. These are the types of supernetwork banks that Haldane and May identified in their study as having more damaging effects if they fail. Regulators decided they needed to hold additional capital. “To a significant extent, these new rules capture much of the underlying picture of our ecology and bank filings,” says Haldane.

Other research is also having an impact. In particular, a measure called DebtRank — introduced in a report co-authored by Battiston — is used by European regulators. DebtRank uses data on bank assets and liabilities to calculate a single figure reflecting the overall damage that each bank’s failure would do to the financial system.⁴

Battiston says this measure was inspired by the PageRank algorithm, created in 1998 by Google co-founders Sergey Brin and Larry Page to rank websites by importance, with the most important sites having the most links to other important sites. DebtRank similarly captures the idea that the most systemically important banks are those that have the most and strongest interconnections with other systemically important banks.

“It’s fair to say that DebtRank helped to mainstream the idea that regulation needs to look at the systemic level to see the onset and spread of financial distress,” said Guido Caldarelli, a physicist and specialist in complex networks based in Ca’ Foscari University of Venice in Italy, who helped develop the measure.

Haldane also notes that regulatory oversight tends to become less stringent over time after a financial crisis, as policymakers especially push to ease rules to spur growth. Since the 2008 crisis, there has been a “gradual, noticeable breakdown of the regulatory framework,” he says. “It’s happened in the US, the UK and the Eurozone.”

“In that sense, having a mini-crisis or a set of mini-casualties — like what we’ve seen so far — isn’t really useless. This can help raise awareness and remind financial markets and financial market participants of the risks inherent in banking.”