Another headwind the world does not need

Recent financial tremors in the US and Europe is surely the last thing the world needed amidst stagflation fears, war, and geopolitical power reconfiguration. A prosaic financial stress shaking confidence in the banking system has added financial stability to policy dilemmas in fighting inflation. The policy response chosen is to err on the side of preventing a systemic crisis at any cost.

Where it came from

Markets around the globe were panicked by the biggest failure of a US bank since the global financial crisis. The collapse in the US, where it started, "seem to have an obvious cause", note Rajan and Acharya (March 27, Project Syndicate). "Ninety percent of the deposits at Silicon Valley Bank (SVB) and Signature Bank were uninsured, and uninsured deposits are understandably prone to runs …. both banks had invested significant sums in long-term bonds, the market value of which fell as interest rates rose. When SVB sold some of these bonds to raise funds, the unrealised losses embedded in its bond portfolio started coming to light. A failed equity offering then set off the run on deposits that sealed its fate." This was an unintended consequence of interest rate hikes and self-inflicted wounds such as unhedged $124 billion SVB bond portfolio, triggering a classic bank run by fearful depositors. The rest is history with several others coming to the fore needing rescue.

The regulators intervened to take control after the horse had left the barn. "What if" stress tests, the gold standard for post-2008 new supervisory regime for minimising the risk of financial contagion, were fixated on the performance of large systemically important banks in the event of "hypothetical severe recessions", paying little attention to large regional banks. The Fed, warned as early as August 2022 about the SVB liquidity risks, also contributed to the problem stuffing banks with uninsured deposits through several bouts of Quantitative Easing,

Markets remain on edge. A relative calm without comfort prevails now, thanks to the provision of huge sums of emergency cash from central banks and some of the industry's strongest players. The Deutsche Bank plunge unsettled the calm yet again. It may be down to an "irrational market" where the risk that negative views going viral to become a self-fulfilling prophecy is growing. "The glass half-empty view is that banks need a lot of money. The glass half-full take is that the system is working as intended," says a JP Morgan stalwart.

Well, maybe. There are deep uncertainties around how it may pan out.

Help or hurt disinflation

Tension between price stability and financial stability is inevitable when a market liquidity crisis occurs with inflation above target. Financial stability is considered a precondition for the effective pursuit of price stability. On the other hand, the central bank cannot cease or suspend its disinflationary policies when inflation is far from being tamed.

The twin problems of inflation and financial instability would normally push the Fed in different directions. It is determined to fight inflation elevated above 2% while at the same time pressed to leave rates unchanged to soothe financial markets. The Fed navigated the conundrum by raising rates by just a quarter-point on March 22, less than the half-point hike that many expected before the collapse of the SVB and the SB. The European Central Bank hiked rates by 50 basis points to try to reduce the 8.5% inflation rate despite jitters caused by the struggles of Switzerland's second-largest lender, Credit Suisse.

A slowdown in credit caused by banking failures may facilitate a landing quicker and harder than projected. Some banks will likely curtail lending to help shore up their finances and avoid running the risk of a collapse. Ironically, this could help the central banks, who have had only limited success in trying to cool their economies through rate hikes. They won't have to raise rates as high as otherwise.

Hazards of moral hazard

The Fed joined the Treasury Department and the Federal Deposit Insurance Corporation to announce that the government would protect all of the banks' deposits. This means all deposits in US banks are insured, admit it or not. The Fed also unveiled an expansive emergency Bank Term Funding Program to provide ready cash for banks and other financial institutions against debt instruments at par value and sweetened the terms for the banks to borrow from its "discount window". With market value well below par for many eligible debt instruments, "the lender of last resort has become the lender of first resort", as William Buiter has observed, offering materially subsidised loans.

These contribute to moral hazard. Incompetent or reckless bank management will not be penalised. There will be an expectation for the regulators to step in when a bank gets into trouble in the future. Bank losses due to mistaken investment decisions are part of the healthy Darwinian mechanism that sustains a market economy through orderly resolution of bankrupt institutions. Moral hazard was contained by letting the banks go bust and exposing the shareholders and unsecured creditors, perhaps even secured creditors, to whatever the banks' mismanagement cost. The residual, covered by the Fed or the federal government, is the price of ruling out the systemic threat posed by bank runs.

Worrying over moral hazard under threat of a systemic crisis is not without hazards either. Cognizant of the systemic hazards, Lawrence Summers warned: "I don't think this is a time for moral-hazard lectures or for talk about teaching people lessons". More recently he lamented "the irony of crisis management is that crises are caused by a lot of excess lending and are resolved by even more lending." The $318 billion the Fed has loaned in total to the financial system is about half of what was extended during the global financial crisis.

What could be next?

There are potential risks posed by the market for commercial real estate. Some analysts project it is heading for a crash over the next two years when millions of real estate leases are going to expire, potentially triggering a domino effect. Companies deciding not to renew their leases or insisting on more favourable terms could drive the value of commercial real estate down across the board. The loans many banks have made against office buildings may suddenly be worth less than they are now, especially with interest rates much higher than a year ago. In turn, this could make depositors and investors doubt banks' financial stability, leading potentially to the same kind of runs seen in March.

The recent round of bank failures is markedly different from the implosion of financial institutions, such as Bear Stearns and Lehman Brothers, that precipitated the 2007-08 global financial crisis. There may be other banks that are in a similar predicament due to the rise in interest rates. However, the increased capital requirements imposed after the 2008 crisis seem to be paying off. Even the banks that have made stupid mistakes mostly lose their own money and not that of depositors.

Yet a multifaceted crisis with no obvious solution cannot be ruled out. We are witnessing a potentially lethal interplay between inflation, a financial crisis epi-centred in the US and a deepening cold war between the US and China on top of the hot war between Russia and Ukraine. The differences in the origins of each crisis won't really matter in making the outcome more vicious than the sum of the parts.

Implications for us

Developing countries like Bangladesh have a lot at stake in how it all unfolds. There may have been some direct hit on our forex reserves to the extent they are invested in long-mature US or Euro bonds. What we need are lower rates, sinking commodity prices and an internationally weaker dollar. We are on the receiving end of being a net international borrower and a user of dollars in most of our international transactions. 

So far, the banking turmoil has not unleashed forces that will reduce borrowing rates in offshore financial markets where we do most of our short-term financing deals. Financial conditions are unlikely to ease even if central banks pause rate hikes. Investors are fleeing to cash in the biggest rush since the onset of the pandemic. Before March, Emerging Markets and Developing Economies (EMDEs) risk assets were generally resilient to higher US interest rate expectations and a somewhat stronger dollar. In mid-March, however, risk aversion picked up as bank failures spread affecting EMDEs with weaker credit profiles. The credit and stock markets are too greedy for rate cuts, but the systemically important central banks remain hawkish about fighting inflation.

Fears of an economic slowdown in the world's largest economy deepened and extended traders' rush out of oil in the wake of the SVB collapse. For most of the past year, after the initial price spike following the Russian invasion of Ukraine, the price of crude has been relatively stable, pushed up by expectations of tight supply and down by recession worries. Since the run-on banks, crude prices after an initial slide moved in a narrow range with oil markets focused on developments in the banking crisis, supply concerns and indications of strengthening demand. The announcement that First Citizens Bancshares Inc will acquire deposits and loans of SVB spurred optimism about the condition of the banking sector. Oil prices also drew support from indications of strong Chinese demand.

The US Dollar Index stood at 102.6 as of 30^th March 2023, down 2.3% over one month, but still 4.4% higher compared to the same time last year. Slowing rates of inflation, a possible policy pivot by the Fed, and fears of a potential recession in the US have pulled the greenback off its highs. The new banking crisis reignited flight to safety towards US dollars, resulting in some appreciation of the USD index after a slide as the SVB story went viral.

Uncertainty is the only certainty currently.

Zahid Hussain is former lead economist of The World Bank, Dhaka Office