(ORDO NEWS) — The problems of the closed banks can be explained by illiterate risk management, but they were only the first to absorb the consequences of the rapid increase in Fed rates. The tightening of the regulator’s policy will inevitably lead to losses for many financial institutions. Moreover, in Europe the banking system is even in a more vulnerable position than in the United States, says Egor Susin, Managing Director of Gazprombank Private Banking.
To describe the current situation in the global financial markets, perhaps, the catchphrase “Never happened before, and here again …” would be best suited. On March 10, one of the largest US banks and the key Silicon Valley bank Silicon Valley Bank with assets of $209 billion rapidly went bankrupt – the bank was in 16th place in the US in terms of size.
It turned out to be the biggest bank failure in the US market since 2008, when Washington Mutual collapsed. Of course, there were also larger falls then (Bear Stearns and Lehman Brothers), but these were investment banks without a classic banking license and deposits.
Along with the California SVB, another fairly large New York bank, Signature Bank, with assets of $110 billion, which was one of the top 30 US banks, is quietly being liquidated over the weekend.
These two banks with a deposit base of $264 billion were in the US deposit insurance system (guarantees up to $250,000), but worked mainly with corporate clients: only about 10% of all deposits turned out to be insured. As a result, the authorities had to urgently guarantee the return of all deposits.
In fact, the Fed will issue about $250 billion to compensate for deposits guaranteed by the US Treasury, providing loans secured (at face value, not market value) of the assets of these banks. The extraordinary generosity of the authorities is due to the fact that the loss of deposits would most likely lead to the collapse of mid-cap banks and a massive outflow of deposits to the largest banks.
Realized Risk
Either way, we have seen a classic banking crisis caused by nothing more than a rate hike by the Fed in response to soaring inflation. Regulators considered the rise in prices to be temporary for too long and were too late to respond.
Someone has already written off what happened to illiterate risk management and bank balance sheet management. It is obvious that all this took place, but it is too early to calm down – the weakest fall first. The very essence of the financial system is that it attracts low-risk short-term resources and converts them into longer-term and risky ones, which it earns on.
The guarantee in this process is the capital stock formed by the financial system. The policy of central banks in recent decades has led to the fact that all assets were formed on the basis of rates close to zero, and the risks were systematically underestimated.
The two main risks that the financial system “buys” are interest rate risk and credit risk. A sharp increase in rates by central banks is the realization of interest rate risk, leading to an unconditional loss for financial institutions.
Yes, some individual banks or corporations are more protected and regulated, they removed part of the risks from their balance sheets by selling them to other market participants, but in general, this did not reduce the risk for the financial system – it was simply redistributed, that is, someone I bought this risk anyway, problems await him.
It must be said here that the largest banks in developed countries after the crisis of 2008 found themselves in conditions of rather strict regulation, so their capital stock is large enough to mitigate the effect of the Fed’s actions. But within the financial system, risks, capital, and profits are distributed extremely unevenly, so such a rapid rate increase, which we saw in 2022, will in any case lead to failures in individual financial institutions.
Moreover, the European banking system may turn out to be more vulnerable here than US banks, since low margins over the past decade make it more sensitive to rate increases, despite tighter regulation.
Choice of Regulators
In such a situation, there is always a buyer of the risk of last resort – this is the state and central banks, whose goal is to prevent the development of events according to a crisis scenario. But now the budgets in both the US and Europe are extremely unstable and in deficit after the huge spending of recent years, including those associated with the pandemic. Public debt is at extremely high levels.
The increase in rates leads to an even greater burden on budgets due to the increase in the cost of servicing debt. For example, the US budget could spend up to $1 trillion this year to service the interest on the debt, which would be double the spending in previous periods.
This greatly limits the ability of regulators to minimize the risks associated with a sharp tightening of monetary policy. Considering that the scale of possible problems depends both on the rate hike itself and on the duration of keeping rates at an elevated level, we have now come to a situation where central banks will have to choose whether to continue to fight inflation or stop financial stability risks. What we have already seen is only the first signs, when the weakest institutions were under attack.
The difficulty lies in the fact that the consequences of the increase in interest rates that have already taken place have not yet materialized, losses are accumulating gradually – this is an inertial process, therefore, it will not be possible to immediately assess the consequences of the decisions already taken by the Fed.
Central banks, pursuing a rather controversial policy, have greatly reduced their ability to fight inflation in recent decades, believing that inflation is gone for a long time. This was one of the reasons for the absolute lack of restraint of the fiscal authorities and the uncontrolled growth of budget expenditures.
The ability to continue tight monetary policy is severely limited by the extremely high debt burden in key economies. Now central banks are likely to have to choose between fighting inflation – and thus trusting their inflation-targeting policies – and the threat of another recession.
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