Recent bank failures have revived fears of a full-blown financial crisis and global recession, but economists warn that the situation is unlikely to lead to a repeat of the 2007-08 crisis. doing.
The sudden collapses of Silicon Valley and Signature banks in the US and Credit Suisse in Europe were partly due to rapidly rising interest rates.
The banking sector’s woes highlight the delicate balance central banks face in trying to keep high inflation in check without putting unnecessary stress on financial institutions.
What are the challenges for central banks?
Policymakers are walking a tightrope, trying to keep credit flowing through the financial system while trying to keep inflation down. Ideally, regulators would be able to raise interest rates by an appropriate margin and pace to bring down the price level without triggering a banking crisis.
The problem for policy makers is that high interest rates, a key tool to curb inflation, may reduce demand for loans, putting further pressure on the banking system on which the entire economy depends for credit flows. There is More turmoil in the banking sector makes a “soft landing” less likely and increases the risk of the global economy slipping into recession.
Rising interest rates also increase the likelihood of a recession in general, as borrowing costs for businesses and households rise, businesses cut new projects and jobs, and consumers cut back on spending. increase.
The World Bank reported in January that rapidly rising interest rates had pushed the global economy to a “razor blade” and warned that the worst-case scenario for 2023 has now become the baseline. Sachs has raised the chance of a US recession next year from 25% to 35%.
Inflation rates vary from country to country, but prices around the world are rising faster than before the pandemic.
According to the International Monetary Fund, global inflation is expected to fall to 6.6% this year from 8.8% in 2022, and fall further to 4.3% next year.
US inflation was 6% in February. The US Federal Reserve (Fed) is eyeing other central banks for a change in interest rates, and he aims to raise inflation to 2%. But analysts have interpreted Fed Chairman Jerome Powell’s recent softening tone as an indication that central banks are acting cautiously.
Wealth manager and behavioral economist Tim Urain told Al Jazeera, “The Fed is now weighing rising interest rates and opposing keeping rates on hold or cutting them, both in lending and in the banking industry. We have to risk causing more chaos.”
What risks do banks face?
Rising interest rates pose some unique challenges to banks’ business models.
For example, mortgage lending becomes more complicated. Fixed-rate loans are immune to rate hikes, so banks cannot use them to offset rising funding costs. You can charge more fees for variable rate loans, but that increases the risk of borrower default and causes more losses.
As high inflation erodes savings, more people are diverting money from banks into assets that can offset rising costs of living. US bank deposit rates have fallen more than 3% since monetary policy began tightening, and last month’s shock accelerated outflows. In February, more than €70 billion ($76.2 billion) of savings flowed out of eurozone banks. This is the largest cash outflow on record.
Cash withdrawals by themselves are not cause for panic, but combined with falling bond prices, they can be a serious problem.
Florida-based financial analyst Kevin Rao told Al Jazeera, “Banks take customer deposits and invest or lend the money for greater returns.
“This exposes you to interest rate risk as your previously purchased bond investments will depreciate in value as interest rates rise.”
Banks use bonds as a safe place to keep depositors’ cash. Yield pays interest to depositors and makes a profit for the bank. However, rising interest rates have led to a significant drop in bond values over the past year. This only results in paper losses unless banks have to sell bonds prematurely to get cash amid a surge in withdrawals.
Such was the case with Silicon Valley Bank, which said it was short of billions of dollars in cash due to premature bond sales. Dismayed investors then caused a run on the bank, hastening its collapse.
“This incident shows that money is tight as individuals and businesses are taking deposits that banks intend to invest over a longer period of time,” said Rao.
More bank failures increase the risk of financial contagion and the onset of a global recession.
What is being done to prevent a global crisis?
Financial institutions are taking precautions to avoid a potential credit crunch that could trigger a global crisis.
When last month’s crash occurred, regulators in the US, UK and Switzerland moved quickly to facilitate takeover deals and deposits. Meanwhile, Brussels leaders lashed out at the strength of the European Union’s banking sector to reassure investors after Deutsche Bank’s shares plunged over concerns that Germany’s main lender could fall next. emphasized the
Last month, the US Federal Reserve Board activated daily currency swaps with central banks in the UK, Japan, Canada, Switzerland and the Eurozone. Accelerated swaps, which are valid until at least April and typically traded on a weekly basis, aim to give peers access to US dollars to keep the financial sector running.
These and other measures are aimed at stabilizing systemic shocks that may occur over the coming months.
More generally, the financial sector is widely believed to be better able to withstand shocks than it was in 2007-08, due to the increased regulation introduced after the crisis.
Among other regulatory changes, financial institutions will be subject to higher capital requirements and stress tests designed to assess their ability to weather a severe recession.