If you’re a banker, it’s been a month to forget. Two regional US banks have gone to the wall, central banks on both sides of the Atlantic have been forced to provide hundreds of billions of dollars in emergency lending to shore up the financial system, and the Swiss financial group Credit Suisse has been ignominiously absorbed into the larger UBS at the behest of its regulator. About half a trillion dollars have been wiped from banks’ stock market valuations.
Although history doesn’t repeat itself, it rhymes sufficiently to ask whether we are on the brink of another global financial crisis. A bit of context for the current troubles might help answer.
Inflation is high in the UK, mainland Europe and the US. The standard macroeconomic policy to arrest high inflation is not to strike hard public sector pay deals; it is for central banks to increase interest rates. Higher rates mean a higher cost of borrowing for everyone, reducing the propensity of households and businesses to spend money on credit and reducing aggregate demand versus supply. Doing this in a way that cools inflation without inducing a recession is a hard balance to strike. This is precisely what the Bank of England, European Central Bank and the US Federal Reserve have been trying to do for the past year.
Increasingly, these interest rate increases are causing problems to pop up in different parts of the global financial system. And the common thread running through this and other recent crises is the bond market, composed of IOUs issued by governments and companies alike.
While Kwasi Kwarteng’s mini-budget was the spark that ignited the financial maelstrom in the UK last autumn, rising interest rates and sinking bond prices in the months leading up to that moment laid the foundations for vulnerabilities among pension funds that were engaging in a form of asset allocation called liability driven investment (LDI) to turn nasty. When they did turn nasty, it took the fall of Liz Truss’s government and an emergency intervention by the Bank of England to steady the system.
In the US, Silicon Valley Bank (SVB) collapsed this month after a depositor run – the second-largest US banking failure by assets in history. The run followed an admission of a near-$2bn (£1.6bn) loss on its long-dated government bond holdings, putting it in need of recapitalisation. Signature Bank and the tiny Silvergate – the two banks who were by reputation the most closely linked to the cryptocurrency industry – were also shuttered as depositors fled.
Government bonds are considered to be the best collateral around. But in its intervention, the Federal Reserve reversed decades of orthodoxy and has offered emergency lending against the full-face value of government bond holdings rather than their (much lower) market value. This sounds arcane, but is telling. It points to a recognition that banks’ unrealised losses on their bond portfolios are sufficiently large as to represent a systemic risk and therefore requires an extraordinary policy response.
At about $128tn, the bond market dwarfs the global stock market in size. It’s where governments, large firms and big banks go to borrow money. As such it plays an absolutely central role in the global financial system. The way bonds are valued is directly linked to market expectations as to the future path of interest rates. Over the past year, central banks such as the Bank of England have surprised financial markets with the pace and magnitude of their interest rate rises. And this has hit bond prices hard. To put some numbers on this, 10-year government bond prices are about 20% lower today than where they were at the end of 2021. Bonds are considered safe – boring even. They have been anything but.
Was Credit Suisse another victim of bond market losses? Not directly. Rather, the firm spent the last decade lurching from scandal to strategic misstep and back again. It built a reputation as Europe’s weakest big bank. Banks require trust to survive, and with failures like SVB and Signature popping up in North America, Credit Suisse’s already nervous depositors and clients found reason enough to flee to safer institutions. With a substantial bank run in progress, there was a very real threat that Credit Suisse would have collapsed had regulators not forced a deal. This would have been truly ugly.
The Bank of England’s response to the LDI crisis was swift and large. So too was the Federal Reserve’s response to the collapse of SVB and Signature, and the Swiss National Bank’s response to the run on Credit Suisse. The context for these episodes is rising interest rates and the financial fallout that such moves bring.
Monetary policy supposedly works with “long and variable lags”. From time to time, it comes through with sharp and nonlinear spikes.
Toby Nangle is an independent economist and spent 25 years as a fund manager at Columbia Threadneedle