There is turmoil in the US banking industry nowadays. First it was SVB a top bank catering to the Tech sector, then Signature bank and then a big one – Credit Suisse which eventually got taken over another Swiss bank UBS. Is this a tip of the iceberg with more banks to follow or is it contained for now.
At first it looked like a contagion with the possibility of banks with relatively weak assets bound to collapse. This fear was exacerbated due to a bank run on SVB bank as within a matter of days a total asset value of 190 billion was wiped off.
The Genesis of the Problem
SVB benefited from more than ten years of “zero money” interest rates as billions of dollars in venture capital for the technology industry poured into the bank. It invested the funds in long-term US treasury bonds in an effort to earn a return. The bank was compelled to sell some of those bonds at a loss though, as depositors wanted larger yields as interest rates began to rise dramatically last year. Tech investors worried when word of that spread on social media, starting a traditional bank run. The second-largest bank failure in US history occurred place 36 hours after that.
The issue with credit Suisse was more bad management and weak internal controls and risk management practices. The bank was badly managed and there were a series of internal scandals that led to losses and ultimately its demise.
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How is the global environment affected?
It is a fact that the collapse of these 3 major banks have caused a certain panic in the market, However the Federal reserve came up with shoring up the funding lines with a bank term funding program in March 2023 which meant that banks could now exchange assets like US treasuries for cash for the full-face amount regardless of the current value. This to a very large extent stemmed bank runs like SVB owing to banks inability to pay back depositors owing to unrealised losses by holding long term govt bonds.
However, the real problem is far from over. The clear and present danger remains a sticky and stubborn inflation level which had initially forced the federal reserve to hike interest rates by almost 425 basis points less than 12 months which is an 8 time increase in the same time period.
For over 10 years western economies got used to easy money with interest rates often at 0 % and during covid at even negative rates. All this resulted in excessive borrowings by both retail as well as corporate borrowers which also led to excessive money supply in the market. This was in the wake of the Global Financial crisis in 2008 where collapse of Lehman Brothers led to a global crisis leading the world into a major recession. Western central banks were quick to rapidly increase the flow of money into the market by printing currency notes and keeping interest rates to near0 levels. While it helped the cause of increasing demand in the market it also led to a debt-based economy where almost anything was underwritten by debt and borrowings. The situation came to a head during Covid where there was a massive infusion of funds in the economy to tide over the crisis of businesses going bust due to a halt in production and demand.
The federal reserve in its wisdom let the free run of easy money play out in the economy which would later have long term implications. The other trigger to the story was the Russia Ukraine war which was the last straw on the camel’s back. Commodity prices shot up and inflation was up to all-time highs like of which was never seen before. Central banks all around the world were now forced to hike interest rates to levels that were not seen before. With inflation in these economies hitting record highs of 10 to 11% central banks were forced to increase interest rates dramatically.
This very sharp increase in a very short period resulted in long term bond yields going very low and exposed most banks with unrealised losses especially in the U.S.
The central banks in these economies have a devil’s choice. They either keep interest rates at current levels and let inflation seep further north or continue with the interest rate hikes which is the only dampener on inflation. However, this comes at an expensive cost. Borrowings become much more expensive, and companies would not get access to cheap funds anytime soon.
Inflation as we see it now is stickier and stubborn and it is unlikely that central banks will reduce interest rates anytime soon to ease the money supply situation. They will continue to have a contractionary monetary policy which will have a direct effect on output, employment, and growth. There is no convenient way to fix to such problem. Inflation will continue to be the main driver of economic stability and the longer it continues the more the pain the economy must go through.
Companies that are highly leveraged will find the going very tough as it now must borrow and pay at prevailing interest rates. Banks will no longer be willing to fund enterprises that are not sound for the fear of accumulating bad debts and becoming nonperforming assets. This will drive the economy down in a downward spiral of low investment, output, and growth. This will also have deep societal implications with many families not being able to support themselves with even basic necessities of survival and will depend of governments on subsidies and cash transfers.
The only silver lining to a dark cloud is that unlike the previous financial crisis which was based on poor underlying securities such as subprime bonds, the problem today is high-interest rates leading to low yields in govt bonds in turn resulting in a very sharp decline in the value of assets of banks who hold these securities.
The measures taken by the federal reserve have brought some relief in the form of protection to both depositors and banks in the form of deposit insurance and the bank term funding program but the key question remains if companies and people around are able to survive and grow in a high cost and high interest environment such as what we are witnessing now. – The answer to that is uncertain.
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