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A week of banking turmoil

by Index Investing News
March 17, 2023
in Economy
Reading Time: 3 mins read
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This was the week that the global banking system finally started to crack under the weight of historic interest rate increases. It began last Friday, with the collapse of start-up lender Silicon Valley Bank. US authorities guaranteed all deposits and offered liquidity to the banking system, but fears spread. By midweek, the troubled Credit Suisse was offered a safety line from the Swiss central bank and US lenders were tapping the Federal Reserve for billions in liquidity. On Thursday, Wall Street banks agreed to prop up First Republic, a California-based lender. Central bankers were left wondering whether they will endanger financial stability if they continue with the rate rises necessary to tame inflation. The question on everyone’s minds is: what will break next?

It was only a matter of time before the fastest synchronised rate hiking cycle by global central banks in 50 years strained another segment of the financial system. The rapid reversal of a decade of loose money has already revealed weaknesses, from the UK pension market crash in September to recent crypto-market chaos. SVB’s demise sparked concerns over unrealised interest rate losses on assets held by banks. But the episode also showed how fears over interest-rate exposures can spill over into wider panic. US bond market volatility rose to its highest level since the 2008 financial crisis, and share prices dropped globally. Credit Suisse fell prey to this crisis of confidence.

Central banks know they risk breaking things as they raise rates rapidly. But the strains are now becoming harder to ignore. This week’s turmoil is a reminder that tight monetary policy not only operates with a lag, but that its effects also do not feed through gradually or smoothly. Policymakers will recall how rate hikes preceded the 2001 bursting of the dotcom bubble and contributed to the subprime US housing sector collapse — which triggered the 2008 crisis. The problem is that the battle against inflation in both the US and Europe is not yet conclusively won. While energy and supply-chain price pressures have eased, domestic price growth remains high.

If central bankers appear to row back on commitments to fight inflation that could equally spook markets that price growth may remain high. The European Central Bank acted effectively on Thursday. It hiked rates by 50 bps, which it had already committed to do, and clearly communicated that future decisions would be data dependent while promising liquidity should the financial system need it.

The Fed faces a harder decision when it meets next week. It still needs to raise rates, but must tread carefully: the banking ructions in the US are more directly linked to high rates than those in Europe. It will need to closely monitor conditions in the lead-up to its meeting. In addition to trying to parse the conflicting US economic data on inflationary pressures, the Fed also now needs to assess how much the turmoil has itself tightened conditions and whether its liquidity facilities offer it enough cover to raise rates at the pace it had planned.

Despite the echoes of events 15 years ago, there are few indications that a 2008-style crisis is in store. The banking system is stronger than it was then, though the past week has revealed regulatory flaws that need correcting. Efforts to stave off contagion through deposit insurance, liquidity lines and reassurance have brought some calm, albeit creating moral hazard. Over-leveraged sectors and financial institutions with rate-sensitive assets and concentrated exposures will, however, continue to be big vulnerabilities in the system. This has been a testing rate-hiking cycle for central bankers as it is. Now that the cracks have widened, it has become even harder.



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