It has been a year since the Federal Reserve started to raise interest rates and banks are starting to fall over in the US. Anybody who thinks Silicon Valley Bank was a one-off is deluding themselves. Financial crises have occurred on average once a decade over the past half century so the one unfolding now is if anything overdue.
The reckoning has been delayed because since 2008 banks have been operating in a world of ultra-low interest rates and periodic injections of electronic cash from central banks. Originally seen as a temporary expedient in the highly stressed conditions after the collapse of Lehman Brothers, cheap and plentiful money became a constant prop for the markets.
Over the years, there was debate about what would happen were central banks to raise interest rates and to suck the money they had created out of the financial system. Now we know.
The action deemed necessary to rein in inflation has deflated housing bubbles, sent share prices plunging and left banks nursing big losses on their holdings of government bonds.
The Bank of England was quicker out of the blocks than the Fed. Threadneedle Street began raising rates in December 2021 and has now raised them 10 times in a row. The European Central Bank waited until July last year before making the decision to increase borrowing costs for the first time in a decade, and went ahead with an increase last week despite news that the banking malaise had spread across the Atlantic to Credit Suisse.
Ignore the fact that the US, UK and eurozone economies have all held up better than was expected in the immediate aftermath of the energy price shock caused by Russia’s invasion of Ukraine. It takes time for changes in monetary policy – the decisions central banks make on interest rates and bond-buying or selling – to have an impact.
As Dhaval Joshi of BCA Research pointed out last week there are three classic signs that a recession is coming in the US: a downturn in the housing market, bank failures, and rising unemployment. Housebuilding is down by 20% in the past year, which means the first has already happened. The problems at SVB and other US regional banks suggest the second condition is now being met. The third harbinger of a US recession is a rise in the US unemployment rate of 0.5 percentage points. So far it is up by 0.2 points.
“Banks tend to fail just before recessions begin,” Joshi says. “Ahead of the recession that began in December 2007, no US bank failed in 2005 or 2006. The first three bank failures happened in February, September, and October of 2007, just before the recession onset.
“Fast forward, and no US bank failed in 2021 or 2022. The first bank failures of this cycle – Silicon Valley Bank and Signature Bank – have just happened. If history is any guide, the start of bank failures presages an economic recession that is more imminent than many people anticipate.”
The Fed and the Bank of England meet to make interest-rate decisions this week and the financial markets think that in both cases the choice is between no change and a 0.25 point increase. Frankly, it should be a no-brainer. Given the lags involved, even a cut in interest rates would be too late to prevent output from falling in the coming months, but against a backdrop of falling inflation, plunging global commodity prices and evidence of mounting financial distress any further tightening of policy would be foolish.
Central banks seem to think there is no problem in achieving price stability while maintaining financial stability. Good luck with that. The Fed, the ECB and the Bank of England have tightened policy aggressively and things are starting to break.
It wasn’t always thus. There was a marked absence of banking crises in the 25 years after the second world war, a period when banks were much more tightly regulated than they are today, and played a more peripheral economic role. Reforms put in place after the Great Depression, including capital controls and the US separation of retail and investment banking were designed to ensure governments could pursue their economic objectives without fear that they would be blown off course by runs on their currencies or turmoil in the markets.
Over the past 50 years, the financial sector has been liberalised and grown much bigger. Regulation and supervision has been tightened since the global financial crisis but with only limited effect. SVB was supposed to be a small bank that could operate with less stringent regulation than a bank deemed to be “systemically important”. Yet when it came to the crunch, all the depositors of SVB were protected, making the distinction between a systemic and non-systemic bank somewhat academic. The financial system as a whole is both inherently fragile and too big to fail.
There is not the remotest possibility of a return to the curbs on banks that were in place during the 1950s and 1960s. Desirable though that would be, there is no political appetite for taking on an immensely powerful financial sector. But that, as has become evident in the past 15 years, has its costs.
One is that economies dominated by the financial sector only really deliver for the better off: the owners of property and shares. A second is that the financial markets have become hooked on the stimulus that has been provided by central banks. A third is that the crises endemic to the system become much more likely when – as now – that stimulus is removed. Which means that eventually more stimulus will be provided, the markets will boom, and the seeds of the next crash will be sown.
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