About the author: Christopher Smart Chief Global Strategist, Head of Barings Investment Institute, and former senior economic policy officer for the US Treasury Department and White House.
The magic of maturity change is at the heart of modern economic development. Yet the trick of taking a $1 deposit and lending it out over and over is also at the heart of every financial crisis.
Bank stocks still reflect fears of a deterioration as clouds clear from last month’s market turmoil. But overall improving financial conditions suggest that concerns about a global cascade of defaults seem misplaced. There will be more accidents, but no systematic multi-vehicle pile-ups.
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The risks are clear. Rising interest rates have created conditions that increase asset-liability mismatches, just as the changing climate has increased the risk of severe turbulence for airline passengers. Decades of falling interest rates have forced investors to reach for yields on long-term investments, but there’s nothing surprising here.
These risks are different from previous crises. For example, during the 1997 Asian crisis, current account deficits and external borrowing exposed banks to exchange rate and funding risks. The 2008 global financial crisis was a classic case of low-priced loans deteriorating as U.S. mortgage losses engulfed the securitized mortgage market, upending precarious financial institutions. .
Today’s risk primarily stems from stress due to liquidity mismatches between assets and liabilities. That’s exactly what you wondered in your initial introduction to fractional reserve banking. But now it’s made worse by the fact that social media and technology have made it possible to withdraw money without crowding around the bank teller and talking to Jimmy Stewart.
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This means many balance sheets will be forced to make painful and costly adjustments if even very safe holdings like government bonds are forced to mark down to current market valuations. . Many Monday morning quarterbacks accused Silicon Valley bank managers of not hedging their interest rate exposure, but a recent study found that only 6% of all U.S. bank assets were in interest rate swaps last year. It was not hedged.
Meanwhile, US regional banks appear to be particularly exposed in commercial real estate. The reassessment can take a long time as managers and employees fundamentally reassess the needs of the office. Venture capital and tech sector stress will exacerbate the pain.
The International Monetary Fund also looks closely at non-bank financial institutions, the so-called shadow banks, which have grown from 40% to 50% of global financial assets since 2008. While providing loans when traditional banks withdraw, the IMF is concerned about accumulation of leverage, hidden pockets of illiquidity and unforeseen spillovers.
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With interest rates likely to rise in the coming months as the Federal Reserve (Fed) and European Central Bank (ECB) wage their final battle against inflation, the risks from these tensions are increasing day by day. It is rising. As banks pay higher interest on deposits and bad debt losses start to accumulate, the net interest margin shrinks.
But there is comfort here that the difficulties ahead can be dealt with. If a rate cut is unlikely before price pressures abate decisively, we are closer to the end of the tightening cycle than it is to the beginning. Risk appetite will be boosted significantly as the market becomes more confident that the next rate move will be lower.
Second, the largest US and European banks still have large amounts of capital and ample liquidity pools to weather further turmoil. If anything, America’s financial giants benefited from massive inflows from depositors at smaller regional banks. European banks have little exposure to commercial real estate and boast near record low levels of non-performing loans.
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Finally, last month’s bank failures may not have been as surprising as the swift and vigorous response by regulators. We’ve never seen deposits run as fast as the $142 billion that would have evaporated off the balance sheets of Silicon Valley banks if the FDIC hadn’t intervened. and intervened.
Perhaps the most comforting aspect of the recent crisis was the Fed’s timely announcement that it would protect all deposits in failing banks and provide collateral funding at face value to other banks. . There are many questions about whether the oversight should have been tighter or whether the wide backstop is encouraging risky behavior. But such a move would go a long way, at least for banks, in addressing the large duration mismatch in assessing the next risks to the economy.
Of course, there are no guarantees against future disasters. A system that lends the same dollar over and over unravels every time trust begins to falter. However, the end of the tightening cycle, the resilience of large financial institutions, and the responsiveness of regulators should keep financial disasters in isolation. And the transformative magic of maturity becomes the next driving force for recovery.
These guest commentaries are written by authors outside of Barron’s and the MarketWatch newsroom. They reflect the author’s point of view and opinion. Please send your comment suggestions and other feedback to ideas@barrons.com.
