No bank is an island (with apologies to John Donne)
This article was written by Richard Horswill. All views and opinions expressed are strictly his own.
The banking fraternity, Government and media talking heads do not seem to want to recognise fully the potential fragility of the global financial/monetary system even though institutions such as the IMF are pointing to risks in the banking environment and the wider global economy. Many continue to discuss idiosyncrasies of the failed banks such as Credit Suisse and SVB. Central banks have been generally cautious on this issue so as not overly to raise concerns, other than to state that they are carefully monitoring the situation and believe that the banks are resilient and have large capital buffers which will be more than enough to ride out a storm. They will of course however need to, in principle and data depending, continue on the current interest rate hiking path that they are on in order to attempt to keep pressure on the current inflation (cost push) that they perceive as the biggest threat to economic stability. The debate however has been muddied recently by some central banks pausing in their hiking cycles (eg the Reserve Bank of Australia and the Reserve Bank of India). The regulators having seemingly been yet again asleep at the wheel in not picking up on underlying issues of somewhat hidden off balance sheet losses in the form of hold to maturity assets in the wake of significant, although some may say unprecedented, interest rate increases. Can this current instability have any potential to play out in the same way as the 2008 Great Financial Crisis?
It is clear that underlying this mini crisis, there seems a bigger one trying to break out which would be incredibly deflationary. Up to now, the larger US banks have been attempting to support smaller banks from deposit flight. Also the US regulator, the FDIC, with the Government have suggested that uninsured depositors should not be concerned! This however may seem to be out of their hands as Congress may need to approve higher deposit insurance levels - currently set at $250K. Questions have also been asked about the insured deposit limits in the UK now as well. Combined with the US actions, the European arm of the crisis has allowed the broken bank Credit Suisse to merge with UBS in a shot gun wedding! Although the separate central banks believe that their local jurisdiction issues are not linked, sometime and somehow these seemingly independent issues may well come together which is why it appears that the hurried actions implemented have been designed to keep a lid on the underlying problems in the hope that they will resolve any systemic concerns. Frankly, these are not the actions of calm and considered authorities but rushed attempts to stem a loss of confidence in the global banking system. Confidence is the key word as commercial banks tighten lending standards and de-risk. This has been evident in just how volatile the bond markets have been and the massive moves, particularly in short dated bonds, as hedging takes place. Interestingly, "bad" steepening in the yield curves is the concern currently as it is the collapse in the short dated yields that is sending the signal that the markets believe the crisis is certainly not over. "Good" steepening would provide for the back end of the curve to rise in line with central bank policy having raised rates at the front end bringing the market viewpoint in line with the policy objective. The market is hedging in readiness for rate cuts on the back of continued uncertainty at best or, more likely, a significant breakdown in the global economy. It does seem on the surface that a financial crisis has been headed off; however, a financial crisis and a monetary crisis are different. It would seem that regulators are of the opinion that stemming individual banking issues will resolve the problem and are content to leave it at that. However, based upon the lessons of Bear Stearns in March 2008, this may not be entirely the case. “No bank is an island,” and therefore could the tentacles of the banking system which stretch far and wide provide for further issues down the line?
The similarities to the 2008 crisis is how the central authorities have little to no control over the actions of the private commercial banks. In simple terms, if the system was performing in a normal way, banks with funding issues could go to a dealer bank in the REPO market and deposit assets in the form of loans/mortgages/government bonds etc in exchange for the required cash with an overnight cost which would vary based upon the strength of the collateral offered. However, it is evident that based upon the actions taken so far by authorities to calm markets, the funding mechanisms are not necessarily working properly primarily due to a lack of confidence in counterpart risk. Unless the collateral offered is of high quality, funding for the banks in need is not likely to happen, which could very well lead to further bank failures piling more pressure on the need for "interventions" from Central bankers and ultimately Government. This points to a much deeper global monetary crisis than one off individual financial bank issues that have seemingly been resolved in exactly the same way the Bear Stearns crisis was handled, only for further crises to come out of the woodwork later, leading to systemic failure. The need for quality collateral has also been highlighted in the demand for short dated government bonds at auction trading at rates well below the offered rate at the US Treasury primary/discount window, indicating significant collateral requirement and thus indicating shortages. It is, therefore, highly likely that the volatility will not completely abate until the underwater portion of assets held in the banking system has been restructured ,principally through the re-pricing of interest rates. Loan books in US regional banks are also now coming under further scrutiny due to delinquency issues particularly in car leasing arrangements. Thus, it would appear that the markets are ahead of the central banks in adjusting the future path of rates by hedging accordingly with potential downside risks becoming ever more present.
In conclusion, it would appear that the central banks remain caught between a rock and a hard place! The current sustained path of interest rate hikes, although satisfying the narrative of fighting inflation, seems rather more about the maintenance of credibility of the central bankers than the course of financial stability. Policy reversals are fairly commonplace historically and will become essential if a continuation of global contagion risk remains intact due to the inability of financial authorities to provide calm to markets and thus provide the necessary confidence in the system. Unfortunately, history suggests, the likely course of action will be one that provides for sticking plaster after sticking plaster which will only enable the market to limp along until another monetary tentacle triggers more contagion within the private commercial banking system as it did in 2008. Let us hope that the financial authorities can steer us into calmer waters by making the right decisions having learned lessons from the previous crisis in 2008.