Finance and Banking: The Looming Banking Crisis

By: Khaled A. BaRahma

Credit: Illustration: Jacob Reynolds, The Wall Street Journal.

Summary:

As a result of California's Silicon Valley Bank's collapse over the past week, the global banking system has been rocked by a series of shocks. As central banks try to fight inflation while ensuring financial stability, those fears have stoked fears that we are on the verge of another banking crisis. Over the last week, concerns over the banking system shook asset prices, causing investors to seek insurance against a sudden stock crash.

In terms of the financial markets, what are we seeing?

This past week, there have been serious strains on the global financial system. New York's Signature Bank collapsed on Sunday following Silicon Valley Bank's collapse last Friday. Following the crash of First Republic Bank's shares, Wall Street's biggest lenders pooled their money to save it, pumping $30 billion (£25 billion) into it. As a result of Credit Suisse's financial crisis in Europe, the Swiss National Bank offered £44.5 billion in lifelines. Although SVB and Credit Suisse have unique issues, there is an indication of greater hardship.

The US Federal Reserve, which serves as the country's central bank, discloses a weekly report outlining the emergency aid extended to American banks in the past seven days. Recently, the amount has surged from $15 billion to $318 billion, which surpasses the initial $130 billion provided at the beginning of the

Covid-19 outbreak comes close to the peak amount of $ 437 billion offered during the 2008 banking crisis following the Lehman Brothers' bankruptcy.

Is it possible that we may experience a recurrence of the worldwide financial crisis that occurred in 2008?

At this point, it is premature to determine if we will face a repetition of the 2008 global financial crisis. Nevertheless, there are optimistic indications that it can be prevented. Firstly, financial institutions are currently in a superior financial position than they were in 2008. During that time, most banks were functioning with meager capital to compensate for the damages incurred due to the collapse of the US subprime mortgage market.

During the 2008 financial crisis, the entire worldwide financial system came to a halt as the extent of losses and the most exposed banks were unknown. However, currently, there is no indication of such a scenario, and banks are obliged to frequently report on their asset portfolio's standards, which are subject to rigorous stress tests.

The Federal Reserve and the European Central Bank are among the central banks that established credit facililities to assist banks encountering cash flow issues. Nonetheless, it should be noted that the global financial crisis initially emerged on a limited scale but rapidly intensified. Moreover, financial institutions, including banks, are currently facing significant losses. A critical benchmark from the 2008 crisis is that trust can vanish swiftly.

What is the reason for the banks making losses?

Following the global financial crisis (GFC), central banks took two measures to address the issue: they significantly reduced interest rates and infused money into the banking system via quantitaive easing (QE). As part of this approach, central banks purchased bonds, mainly issued by governments, and traded them for cash, which eventually circulated throughout the economy. Another round of interest rate cuts and QE was implemented at the onset of the Covid-19 pandemic.

Due to the surge in inflation, central banks have altered their approach by increasing interest rates and initiating bond sales. While bond prices were elevated under the QE programs, they have plummeted significantly over the past year as the QE has been reversed. The assertive steps taken by central banks have caused commercial banks to experience substantial and unforeseen losses. One such bank, SVB, had invested significantly in long-term US government bonds. However, with the sudden rise in interest rates, the value of these bonds declined, leading to a considerable loss when the bank was forced to sell them to meet customer demands for cash, which caused a significant impact on the bank's balance sheet.

What is next?

Central banks are in a predicament because their two primary roles - maintaining financial stability and keeping inflation under control - avoiding conflict. To reduce inflation, central banks raise interest rates and reverse QE to slow economic growth. Despite the European Central Bank's decision to proceed with a scheduled interest rate hike on Thursday, the downside of these measures is that certain banks may find it difficult to cope with the resulting harsh conditions.

The recent crisis at SVB has led financial markets to anticipate that interest rates will reach their peak level sooner and at a lower rate than previously expected. As a result, markets are closely monitoring the interest rate decisions of the Federal Reserve and the Bank of England next week. Some argue against further increases in borrowing costs, reasoning that the impact of the increased interest rates from the past year has not yet been fully felt and that commercial banks are already mitigating the effects of issues at SVB and other institutions by decreasing their lending. The risk of recession has significantly grown in the past week.