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This article appears in the April 2023 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

Recent stress in the global banking industry is a reminder of the essential role confidence and trust play in the financial sector, and of how fragile these factors can become.

In a flashback to 2008, the financial world witnessed the failure of two sizable U.S. banks — Silicon Valley Bank and Signature Bank — and the forced marriage of the once-venerable Credit Suisse with its main rival, UBS Group.

Regulators featured prominently in both instances. Swiss authorities engineered the merger of its banking giants, extending explicit guarantees to get the deal done, while U.S. authorities essentially issued a blank cheque to depositors at shaky U.S. banks by promising to backstop their holdings beyond the deposit insurance limits.

In both cases, policymakers acted quickly to prevent greater damage to both their domestic banking industries and to the wider financial system. However, the underlying conditions that prompted these actions haven’t gone away. The episode proves once again that, despite efforts in the wake of 2008 to create a world in which big banks are allowed to fail, when stresses that could take down a large financial institution actually materialize, regulators are reluctant to risk broader contagion.

By throwing out deposit insurance limits during the crisis, U.S. authorities made it clear that if a teetering bank is big or important enough, failure still is not an option. Yet the rescue effort hasn’t altered the fundamentals that led to the bank failures: the impact of higher interest rates and the prevalence of large, unrealized losses on bank balance sheets, coupled with a shortage of liquidity amid declining deposit funding. While regulators have seemingly shored up faith in the banking system, that faith may prove temporary as thousands of smaller U.S. banks grapple with similar challenges in the months ahead.

Hopefully, the system has stabilized enough that the financial sector won’t have to fully confront these issues until conditions ease, giving stressed banks more room to manoeuvre. Still, this recent episode is a blunt reminder of the crucial role confidence plays in holding up the global financial system — a lesson that must not be forgotten when financial sector rules are being crafted and risk-friendly reforms are touted.