Leo Tolstoy opened Anne Karenina with the principle that all happy families are alike, but every unhappy family is unhappy in its own way. The same could be said about the recent troubles with Silicon Valley Bank (SVB) and Credit Suisse.
SVB was not subject to various stress-testing regulations other banks had to follow. Its client base was centred on tech companies, which are particularly vulnerable to short-term liquidity problems. Credit Suisse was a normal global bank – indeed ‘a globally systematically significant financial institution, by the international Financial Stability Board’s reckoning – with a reputation for bad management and long-standing weaknesses. Both came a cropper in their own way.
Yet that the two both fell into trouble within a week of each other is obviously no coincidence. They are examples of the stress that the global financial system is coming under following interest rate rises – something for which our own shenanigans with Liability-Driven Investments (LDIs) last year was the proverbial canary in the coal mine.
For the past 40-odd years, interest rates have largely trended downwards – especially after the sub-prime mortgage crisis brought the global banking system to the precipice of collapse in 2008. In this country (for example), rates went from 5.75 per cent in July 2007 to 0.5 per cent by March 2009. Central banks also pumped money into the system via Quantitative Easing (QE).
Instead of lending this money out to firms and households, banks largely used it to buttress their balance sheets. This not only meant the recovery from 2008 was particularly sluggish, but it also prevented money-printing from becoming inflationary. Banks became used to it; what was originally a tool for emergencies became habitual. A lack of inflation meant there was no pressure for interest rate rises, and a lot of banks were doing very well out of easy money, thank you very much.
And then came Covid.
The Bank of England printed more money in 2020 than it had in the preceding 12 years since the crash. Combined with the supply shocks generated by closing and then re-opening the economy, inflation returned. And once the Federal Reserve, Bank of England, and European Central Bank were no longer sleeping at the wheel, interest rates rose to contain price rises.
The central issue is that these rate rises have occurred very quickly. In the United States, the hike from near-zero to almost five per cent is the fastest rise since the Second World War. Rises in interest rates cause asset prices to fall, meaning those banks and financial institutions which are not prepared for such hikes suddenly find themselves vulnerable to liquidity crises, as they discover they do not have the ability to meet their creditors’ demands. Cue It’s a Wonderful Life – or last year’s LDI farce.
The message coming out of central banks at the moment is that these are all one-offs – families unhappy in their own way – and that the system remains fundamentally sound. Nothing to see here; move along, please. Yet the LDIs, SVB, and Credit Suisse all became insolvent rapidly, and under the noses of the very regulators who are supposed to keep this system secure. Naturally, investors are taking central banks’ reassurances with a pinch of salt.
So far, central banks have been making liquidity rapidly available to the various banks involved, and swiftly arranging takeover deals where possible in order to calm the markets. Announcements like the £65 billion made available by the Bank of England last autumn to bail out the LDIs, the Federal Reserve’s Bank Term Funding program for quick cash, or the expansion of US dollar swap-line arrangements today, are all tonic for jittery nerves, designed to close the problem down and prevent panic spreading.
They hope that this means they can return to business as usual: namely, paring down on inflation. But the markets are now expecting a halt to further interest rate rises of any great size. Although the ECB went ahead with another hike last week even as the Credit Suisse farrago unfolded, forecasters increasingly believe it is a case of this far but no further. Betwixt now and higher rates stands Gandalf.
What Andrew Bailey, Jerome Powell, Christine Lagarde, and co will want to avoid is having to cut interest rates and loosen monetary policy again. US Inflation was at six per cent in February. It was 10 per cent in the UK, and 8.5 per cent in the Eurozone. Ending efforts to bring inflation down before inflation has returned to normal levels risks entrenching it permanently. Investors lose confidence that the central banks are serious about doing their jobs, and budget price rises accordingly.
Even intervening to provide liquidity to struggling banks can raise fears that monetary policy might loosen, even if it is designed to restore confidence. It suggests to investors that central banks will be willing to once again pump the system full of cash to prevent failures. Of course, banking failures would be one of the easiest routes to deflation – if an extraordinarily messy and painful one.
Central banks are thus positioned like that coach at the end of The Italian Job. One wrong move in one direction and they might spark further panic; one wrong move in the other and they might entrench inflation for the foreseeable. They hope that with enough judicious policymaking (and crossing of fingers) they can get that gold home, another crash or stagflation avoided.
But recessions and panics can only be swerved or delayed, not avoided. For a decade, we have deferred the pain associated with interest rate hikes: the businesses they see go under and the bad banks they threaten. You might not be looking for a financial crisis, but a financial crisis is looking for you. Easing off now would only be to stick our fingers in our ears and hope that the rain will go away and come back again another day.
All of this is very bad news for Rishi Sunak. Any return to inflation would sink one of the five pledges upon which he has staked his premiership – and any repeat of 2008 would obviously be catastrophic. He may have seen inflation coming before most. But he is as vulnerable as anyone to crises that even the regulators tasked with managing can not see coming. A moment’s sympathy, perhaps, for Liz Truss.
The one grim point of light for this life-long Eurosceptic will be that things are likely to become even worse across the Channel. Our response to the crash was hardly perfect, but our banks are at least better capitalised and, as far as we know, no longer engaged in the same risky behaviour. With the caveat, obviously, that it seems we know much less than we thought.
Last time around, the crisis began in America and Britain but induced the most pain in the Eurozone. The continental banking sector was both more vulnerable, and less well-equipped, hampered by the fundamental deficiencies of the Euro structure. With the ECB having hiked interest rates to 4 per cent, it is only a matter of time before the EU faces the same crises for which it is currently blaming Anglo-Saxon – and, erm, Swiss – capitalism. Do you think that junta of Belgian traffic inspectors has any idea what’s coming?
What all this means is that the long political and economic nightmare that has largely endured since Northern Rock went belly-up is far from over – and could get an awful lot worse. Still, good news about the chocolate oranges!