US, European banking systems are at serious risk due to rising interest rates

By Staff Reporter | DAWN Apr 10, 2023

The collapse of Credit Suisse, a 167-year-old institution, is a more significant event for the global financial system than the collapse of Lehman Brothers during the 2008 global financial crisis.

Lehman failed since it had losses on bad investments and did not have sufficient capital.

Credit Suisse on the other hand was stable and had sufficient capital. It failed due to a run on its deposits caused by fear and panic of its depositors.

Even a $50 billion support by the central bank of Switzerland failed to change the sentiment and the bank faced outflows of more than $122bn within three months.

Eventually the regulators were forced to merge it with UBS and provide liquidity of $100bn to UBS for support.

A few weeks earlier, the US government had to commit to support the deposits of three – Silicon Valley Bank, Signature Bank and Silvergate – which had faced a similar run.

The reason why these developments are far more dangerous than the 2008 crisis is that they shows that the sentiment of markets is so weak that even a relatively stable bank, with all the support of the government, could face a run.

While the last few weeks have been stable, there are fears that other banks such as Deutsche Bank in Germany could face a similar crisis.

First Republic Bank has seen outflows of $70bn (40 per cent of its total deposits) and PacWest has lost a fifth of its deposits.

Both banks have sought liquidity from the US Fed. Over the past two weeks, small banks in the US have seen a total of $190bn and large banks have seen outflows of $23bn.

People are moving money away from banks into money market mutual funds.

What’s causing this?

The primary trigger for the banking crisis is the rise in US interest rates.

Until last week, the tightening cycle in the US was mainly hurting vulnerable emerging economies, who were suffering from an outflow of capital towards the US dollar.

The US and Western banking system is now an unintended and unexpected casualty. Most US banks had invested their deposit holdings in US government bonds.

The sharp rise in interest rates means that the prices of these bonds have fallen substantially. So, when depositors ask for their money back, the bank is forced to sell these bonds and incur a loss.

Their other investments in previously hot sectors such as venture capital, private equity and real estate are illiquid and probably also now valued at prices far lower than what they paid for.

This is what happened with Silicon Valley Bank. They were forced to sell their holdings of US bonds and incurred losses of $21bn, which essentially made the bank insolvent.

According to the chairman of US Federal Deposit Insurance Corporation (FDIC), US banks have unrealised losses of over $620bn due to investments in low yielding government bonds.

To make the crisis even worse, US interest rates have still not peaked and are expected to further increase by at least another 25 basis points to 5.25pc.

This means even more losses for the banking system.

The run on banks has some parallels with the GameStop saga. In the digital age, news and fears move quickly through social media and with digital banking, it is far easier for customers to withdraw their deposits.

Some blame a single US venture capital fund for leading to the run on Silicon Valley Bank.

Some are comparing the current crisis to the Savings and Loans Bank crisis of 1980s which led to a $125bn loss and wiped out many small banks in the US.

It created zombie banks, which could not lend money as they had to shore up liquidity.

Similarly, in the current crisis, regional banks in the US who have taken emergency funding from the Fed will have to stop lending and eventually the credit squeeze will lead to a sharp economic slowdown.

I fear that that crisis will spread and might require a global coordinated effort, similar to what we saw in 2008.

Tragically, the rise in inflation, which has prompted this cycle of interest rate hikes, is eventually tied to geopolitics.

Most of the inflation is caused by high energy prices and disruptions to global supply chains caused by the US-China trade conflict.

Supply chain inflation is more stubborn and unresponsive to monetary policy. Deglobalisation is structurally inflationary. High inflation would eventually also lead to political issues, which are already evident such as protests in France and labour strikes in the UK.

Another outcome of the Swiss banking crisis is that it could lead to outflow of private banking deposits to other regional banks in the Middle East, Singapore and Hong Kong.

The $122bn deposit outflow from Credit Suisse must have landed into larger US banks such as JP Morgan and Citi and global banks such as HSBC.

With elections in the US next year, the policy choices for the government between curbing inflation and avoiding a hard recession look increasingly difficult, and the outcomes look very grim.

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