The world is currently facing a banking crisis reminiscent of the 2008 global financial crisis –although policymakers are reluctant to draw the comparison.
This comes after central bankers around the globe raised interest rates at the fastest pace in history to fight inflation. This was necessary because prior to the post-lockdown period, interest rates had been at record lows, in some cases even going negative.
This current crisis has already claimed three banks in the United States (Silvergate, Signature and Silicon Valley), and one Swiss bank (Credit Suisse). Unlike the 2008 bank failures – whose immediate cause was the inability of banks to get short-term funding because the assets they could offer as collateral were viewed as toxic – the current crisis is a classic bank run. In the US, the Federal Deposit Insurance Corporation (FDIC) provides insurance for bank deposits of up to US$250,000, so it is depositors with sums larger than this that are causing the issue.
In a bank run, enough depositors at a bank withdraw their deposits at the same time to make the bank unable to meet its obligations to some or all of these depositors. The depositors are the lenders to a bank and therefore deposits are liabilities for a bank, while the loans that the bank creates are the assets of a bank. The problem is that the assets of a bank may be loans that are not due for perhaps months or years, while deposits can be withdrawn either immediately or in a shorter time span, such as three months, depending on the type of deposit.
A bank always keeps enough cash on hand to satisfy the withdrawals it believes it is likely to face, but a likelihood is not a certainty, especially when a black swan event occurs, like interest rates increasing at the fastest pace ever.
A prudent bank would endeavour to match deposits to assets by making sure that deposits could only be withdrawn after it has received repayment on an equivalent amount of loans, but this bank would not attract many depositors because the main attraction would be as a secure place to warehouse your money and not a place to earn interest on a loan that you could withdraw at any time.
So how did increasing interest rates cause the latest banking crisis?
2008 financial crisis
First it’s important to understand what came before. After the 2008 financial crisis, interest rates dropped to their lowest levels ever. This served to push banks to lend out on longer and longer terms. This is because in general the longer the term of the loan, the higher the interest rate on that loan.
Also, central banks are most in control of short-term interest rates, losing control over rates as lending terms get longer. Of course short-term rates eventually act to influence long-term rates but never to the same level; long-term rates would still be higher (the exception is a yield curve inversion which is comparatively rare and temporary).
So, with banks holding longer-term loans and paying low interest rates to their depositors because of central bank interest rate manipulation, when interest rates were raised, depositors found themselves with options for generating a higher yield on their cash. This is especially true for depositors who keep more than US$250,000 in the bank. Such depositors will be dominated by wealthy individuals and businesses, people who have access to every asset class, including government bonds.
Central banks in general use short-term government bonds to transmit monetary policy. In simple terms, they sell short-term government bonds when they want to increase interest rates and buy them when they want to lower rates.
Since governments are the currency issuers, all other interest rates in that economy are set based on the government bonds which provide the risk-free yield (risk-free in the sense that a government issuing debt in its own currency can always pay you back the nominal amount you lend to it, they just can’t guarantee the purchasing power). So when central banks increased interest rates, suddenly depositors had higher-yielding, risk-free alternatives for putting their money.
As more and more depositors withdrew their funds to earn higher yields elsewhere, a bank like Silicon Valley Bank (SVB) had to sell the assets it owns to meet the demands of these depositors. These assets just so happened to be long-term government bonds, which had fallen in value because the central bank was raising interest rates (the higher the yield the lower the value). The bank would have been fine if it had been able to hold the bonds to maturity, but depositors wanted their money immediately and the bank had promised to honour this promise.
Interest rate manipulation
So the latest crisis is caused by government interest rate manipulation through the central bank.
We will experience more and more of these crises as long as this practice continues. What is needed is to allow the market to set interest rates.
The current “solutions” will only create a greater moral hazard and set the stage for a bigger crisis in future, just as the “solution” to the 2008 crisis is causing the current crisis.
[Image: NikolayF.com from Pixabay]
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