Dr Gerard Lyons is a senior fellow at Policy Exchange. He was Chief Economic Adviser to Boris Johnson during his second term as Mayor of London.
Simply put, you cannot undo a decade and a half of excessive cheap money policies in a short space of time without there being severe consequences. In the aftermath of the 2008 Global Financial Crisis (GFC), exceptionally low interest rates and excessive quantitative easing were the hallmarks of policy in most Western economies, including the UK.
This changed at the start of last year, as inflation soared, and since then the speed and scale of monetary policy tightening has been significant. To combat the soaring inflation that central banks had completely failed to anticipate, they raised policy rates. The Bank of England hiked the policy rate from a low of 0.1 per cent in December 2021 to its current four per cent, plus it has begun to reverse Quantitative Easing (QE).
However, the very act of tightening has exposed the cracks in the economic and financial system. The consequences of this have initially been felt in the over-leveraged parts of the economy – where borrowing or debt are high – or in specific parts of the financial sector, as we saw last autumn in the UK with the LDI pension fund crisis. More recently we are seeing its impact in the US, where banks have been either unfortunately exposed or poorly run.
This has prompted questions as to whether another financial crisis is imminent.
It is important to understand that cheap money has not only fed asset price inflation and contributed to the current bout of inflation, but it also had a distorting impact on the financial sector. As I highlighted in the The Guardian in 2021 and noted in the Financial Times early last year: “cheap money policies, through low policy rates and its quantitative easing programme of asset purchases, have contributed to financial market instability. Low policy rates led markets not to price fully for risk, encouraging speculation. Meanwhile, QE has distorted the gilts market.”
Thus, the transition to tighter monetary policies will force markets to price properly for risk and, as we are seeing, may lead to liquidity problems for some institutions.
The danger is that a crisis of confidence has engulfed parts of the banking system following the collapse in the US of Silicon Valley Bank (SVB), Signature and Silvergate banks, as well as continued concerns about First Republic Bank. This has been followed by the implosion of Credit Suisse which has suffered unique long-term reputational challenges amid a series of scandals and poor management.
While no-one should be complacent, the initial evidence is that current problems are specific and not systemic. In the US, the concern was focused on banks who were seen as not having managed their interest rate risk, with a mismatch between assets and liabilities. This triggered a liquidity problem as depositors moved quickly to move their funds.
The great financial crisis exposed the scale of interactions across the financial industry, so contagion then was high and rapid. Consequently, policymakers now have reacted quickly – keen to limit contagion and market turmoil. Sizeable liquidity has been provided by central banks, and deals brokered, not just with UBS acquiring Credit Suisse but even with HSBC acquiring SVB’s UK arm.
However, not all aspects have been well received by the markets, with the Fed’s response seen as encouraging moral hazard as they safeguarded all depositors. Meanwhile, in Switzerland, the capital structure that is normally followed in such events was tweaked to protect shareholders before some bondholders, perhaps for domestic political reasons. Policy decisions like these can have unintended consequences and add to market concerns about how problems may be predictably resolved elsewhere, and whether accepted rules might be tweaked.
Despite all this, a crisis on the scale of the 2008 GFC would seem unlikely. I remember it well, being one of the very few to predict a financial crisis, and it does not feel like that now given the many steps and policy measures taken in its wake, such as boosting the capitalisation of larger banks, a greater focus on prudential supervision and conduct regulation, alongside enhanced governance. Furthermore, many of the problems that hit in 2008 were already evident beforehand and the current situation is not the same.
Stepping back, although bank shares have fallen the UK banking sector has not been directly impacted by this crisis, and the general perception is that it is in good shape.
Before 2008, the regulatory pendulum was at one extreme, reflecting light self-regulation, and since then it has swung in some aspects to the other extreme. While some may use the present crisis as a justification for no change in the regulatory landscape, this should be resisted. There is a need – as touched on in the recent Edinburgh Reforms – to get the regulatory balance right, both to aid the City’s competitiveness and economic growth while also ensuring financial stability.
One challenge is that the existing regulatory environment incentivises banks to lend to the property sector and to buy government bonds. While these areas are seen as low risk, they would likely suffer if interest rates were to continue to rise sharply. Thus, another important development post-2008 has been the increased focus on stress tests to identify potential risks.
As Warren Buffet famously said post the Great Financial Crisis, “it’s only when the tide goes out that you learn who has been swimming naked.” Therefore, there is always the danger that higher rates and economic slowdown could expose further underlying problems and trigger higher non-performing loans.
Preventing this contagion from spreading into the wider economy, or across the global financial sector then becomes the challenge. This explains why central banks across Western economies are now pumping liquidity into the financial system, and why markets now believe interest rates need to stop rising aggressively and could even start falling.
Compared to 2008, a major worry is that the ability for policy makers to respond now is severely limited. Globally public debt levels are at an all-time high and, as we saw in last week’s Budget, the UK has extremely little room for fiscal manoeuvre given its self-imposed fiscal rules.
What then for monetary policy? The issue of ‘financial dominance’ has emerged in the debate. Should central banks be dominated in their thinking by worries about the financial sector’s problems, or should they continue to tighten policy to curb inflation? The fragile nature of the economic recovery, despite solid jobs markets, should already be factored into their plans.
The focus of global markets will be on the Federal Reserve, who have signalled a bias to tighten, but who now face a mounting domestic banking crisis.
Here, the case for the Bank of England to pause is clearer. Tighter monetary policy works with a long and variable lag, which is often overlooked. Consequently, with the monetary tightening over the last year still feeding through, there is a strong case for the Bank to pause on rate hikes and on reversing QE. Last week’s Budget showed the Office for Budget Responsibility expects inflation to decelerate from 10.7 per cent now to 2.9 per cent by year-end and to undershoot its target next year.
While a financial crisis should be avoided, this can never be a given as confidence is always the key and can sometimes be very fickle. This must be factored into current thinking, in order to align the economic fundamentals, policy and confidence.