Apparently, every bank and its story. In the case of Silicon Valley Bank (SVB) which collapsed at the weekend, one could find double trouble. On one side of the balance sheet, deposits of start-ups, large customers and it turns out that there are also quick responders, who escaped from the bank with zero warning. And on the other side, tens of billions that the bank invested in “safe” bonds – whose value dropped with the rise in interest rates. The bank managed risks in a particularly bad way, the regulator did not wake up in time and that too after the legislators loosened the regulations, and the result was a crash.
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Even in the case of Signature Bank in New York, special circumstances can be found: it bet on customers from the crypto sector, and fell when the industry ran into difficulties. And what about Credit Suisse, whose stock fell into freefall? This is no longer necessarily surprising. In the last decade, one can point to a long chain of scandals in which the bank was involved, including crashes such as those of the Archagos hedge fund and the fintech company Greenseal.
In short, each crash can have its own explanation. But what if they foreshadow a bigger crisis that is coming? For that matter, it is possible to go back to the summer of 2007, a full year before the outbreak of the financial crisis. Within a few months, there was the collapse of two hedge funds managed by the American investment bank Bear Stearns, the freezing of the hedge funds of the French bank BNP Paribas, and then the collapse and bailout of the British bank Northern Rock. In retrospect, these were the swallows that heralded the coming of the financial crisis. Let’s hope we’re not at a similar moment.
“Things are fine until they are not fine,” stated Prof. Kenneth Rogoff from Harvard, in an interview we published last Thursday. Rogoff, formerly the chief economist of the International Monetary Fund, explained that an environment where interest rates are rising “exposes the weaknesses you may have. It’s always a nerve-wracking situation for policymakers.” The point, according to Rogoff, is that often the problems surface “quite suddenly.” A few days after we spoke, Silicon Valley Bank collapsed.
less belligerent
There is a reason for the interest rate increases, of course. Central banks raise interest rates because inflation is still high. Just this week, the US consumer price index data was published, which showed that core inflation (minus energy and food), remains stubborn, and stood at 0.5% in February.
As Rogoff explains, at first it is relatively easy to lower inflation, but as you get closer to the target, it becomes difficult. In his metaphor, the last few pounds on a diet are the hardest to lose. Therefore, as of last week, Rogoff was convinced that the Fed interest rate would still rise to 6%.
It was last week, when Fed Chairman Powell also gave a bellicose speech. Markets expected the Fed to raise interest rates by another 0.5% this month. But this week’s events may call all that into question: With the banks reeling, it’s suddenly unclear whether the Fed will continue on the same path of Rate hikes. In other words, the shocks may force the Fed to slow down its war on inflation. At its meeting next week, the Fed’s Open Market Committee may raise interest rates as little as a quarter percent, or not at all.
The fear of monetary tightening
“Financial dominance”, this is how Prof. Marcus Bronheimer from Princeton diagnosed the phenomenon this week (on Twitter). The central bankers, he elaborates in an article he published this month in the IMF’s magazine, have a particularly acute headache these days. After the financial crisis, their goal was to stabilize the financial system, and stimulate the economy. Conveniently, they could achieve both goals by flooding the system with money, including aggressively lowering interest rates, then buying a mountain of securities.
Today the situation is completely different, Bronheimer explains. The war on inflation collides with the war on financial stability. The private sector and the capital market have developed a dependence on the liquidity provided by the central banks, and now the central bankers are facing limitations on their ability to operate. They cannot necessarily raise the interest rate and reduce their balance sheet as they would like, for fear of harming financial stability. This is the financial dominance. “In such an environment, monetary tightening can wreak havoc in the financial sector, and make the economy even more vulnerable.”
One of Bronheimer’s recommendations to the central bankers in this situation: to tighten the supervision of the financial system as a whole, including close monitoring of dividend payments (which may erode the banks’ security cushions).
The person who publishes an article in the same issue is Prof. Raghuram Rajan, who replaced Rogoff at the IMF, and also later served as the governor of the Indian central bank. Rajan also talks about financial dominance, and mentions that the central banks, which today find themselves torn by the dilemma between fighting inflation and maintaining the stability of the system, are not necessarily “innocent bystanders”. According to him, today they are reaping the fruits of the unconventional policy they followed after the crisis. His lesson: “less is more”.
The debate will continue, and we will see what conclusions the central bankers will draw. In the immediate phase, it remains to be seen whether they will be able to stop the panic in the markets, which was renewed after it seemed that the situation had stabilized. Then the question is whether they will feel able to continue with the interest rate hikes as planned, or whether the turmoil in the markets is too dangerous. We will find out the answer next week, and maybe even before that.