Did the global banking system narrowly avoid a major crisis that could have toppled it after three US banks collapsed, and did the probability of fear contagion spreading across the rest of the world decrease as a result? What lessons can we learn?
In March, the banking sector experienced a pivotal moment when Silicon Valley Bank, Signature, and Silvergate in the U.S., and Credit Suisse in Switzerland, collapsed in a domino-like fashion.
Fortunately, the global banking system seems to have avoided a major crisis that could have caused it to collapse. However, financial decision-makers should not become complacent after successfully intervening to prevent the spread of the crisis to other financial institutions.
What occurred resulted from severe financial vulnerabilities that accumulated over years of low-interest rates, reduced volatility, and generous liquidity. The banks’ failures were caused by poor risk management and a lack of business diversification. During the pandemic, the sector built up very large deposits, punctuated by extensive monetary stimulus operations with near-zero interest rates, and invested a large portion of its inflated portfolio in low-risk Treasuries without adequate precautionary measures, exposing it to interest rate risk.
Startingly, those responsible for supervising and enforcing regulations seemingly failed to do so. In 2022, regulators who were aware of similar warning signs sent alarms to several banks to normalize their situation but did not verify whether proper action was taken.
Read: UBS acquires Credit Suisse for 3 billion Swiss francs to end bank crisis
Re-imposing paramount banking rules, including repeated stress tests, on banks like Silicon Valley, is crucial. Banks with more than $50 billion in assets needed provisions between $100 billion and $250 billion, a category that Congress relieved of such burdens just five years ago.
The recent events highlight the importance of trust in the banking and financial sector. The collapses occurred when depositors no longer trusted their banks and rushed to withdraw their money. (Deposit withdrawals from Silicon Valley reached $42 billion in one day.)
This is a type of fear contagion that rapidly spreads from one bank to another, as well as from person to person, leading to queues forming quickly to withdraw funds, both in person and online. This exacerbates the problem and puts the entire banking system under pressure.
Depositors have been steadily withdrawing their money for some time, opting for low-risk money market funds that provide them with returns that far exceed the interest earned with banks. Evidence of this is the fact that money market fund assets rose to record levels in less than a month (between March and April), with an influx of about $280 billion.
These actions naturally have repercussions on bank profits. Most Wall Street banks reported lower quarterly earnings and now face a gloomy outlook for the remainder of the year, as the banking crisis and a slowing economy are expected to hurt banks’ profitability.
The International Monetary Fund warns of “severe” risks to the global financial system and that financial turmoil will impact global economic growth, believing that weaker banks face more pressure if central banks continue to raise interest rates to combat inflation. The IMF hints that significant deterioration in financial conditions could occur when anxious investors try to test the “next weakest link” in the financial system, as they did with Credit Suisse.
What about liquidity?
The recent events call for a re-evaluation of the assumptions underlying the Liquidity Coverage Ratio and Net Stable Funding Ratio, which were established in the Basel III standards after the 2007-2009 financial crisis that required taxpayers to bail out lenders.
The Liquidity Coverage Ratio, which requires banks to have enough high-quality currency or bonds to withstand market pressures for a month, is set at 100 percent. The Net Stable Funding Ratio aims to reduce long-term financing risk.
The U.S. only applied Basel standards to its largest banks, excluding Silicon Valley. The blame for recent events lies not only with the banks but also with supervisory authorities who failed to enforce adherence to prudential standards, which has shaken the foundation of the global banking system.
Credit crunch?
Although monetary and financial authorities acted quickly to prevent the contagion of the banking collapse by taking drastic measures, the saga is not over. As rate hikes continue to tighten monetary policy, banks will tighten credit lending standards, especially if deposit withdrawals continue to occur.
Federal Reserve Chairman Jerome Powell stated that the Silicon Valley collapse and the disruption it caused in the banking system “is likely to lead to stricter credit conditions for households and businesses, which in turn will affect the economy.”
In other words, by raising the benchmark interest rate used by banks to lend money to each other, tighter monetary policy makes it harder and more expensive for consumers and businesses to obtain loans.
This theoretically decreases demand for credit-financed goods and services and also reduces inflation over time. However, as lending becomes more difficult and expensive, fewer companies will expand, more projects will fail, and hiring will decelerate, laying the foundation for an economic slowdown.
The concern is that the spiral could extend to mortgage lending in America and Europe, with talk of U.S. developers defaulting on a significant portion of the $3.1 trillion in U.S. commercial real estate loans pending, according to Goldman Sachs.
The European Central Bank has cautioned that investing in commercial real estate poses a risk to financial stability, given its exponential growth over the past decade. The net asset value of real estate investment trusts has more than tripled to over 1 trillion euros ($1.1 trillion) in the past decade, enhancing their connection with real estate markets.
It highlighted the danger of investors having frequent opportunities to withdraw funds, while the assets themselves are entirely illiquid.
While the Federal Reserve may be content with credit tightening, as it assists in its efforts to contain stubbornly high inflation, it also raises the likelihood of a recession this year. As the renowned economist Nouriel Roubini put it, “We’re heading for a recession and financial instability caused by having to raise interest rates because inflation is too high, resulting in inconsistency and a trilemma: We cannot achieve price stability, maintain economic growth, (and) have financial stability at the same time.” He added, “As a result, we will ultimately face an economic and financial collapse.”
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