What is happening in the financial markets and could there be a global crisis? | Economy

Economy

The banking system is reeling after a series of shocks, but is in better shape than at the time of the 2008 crash

Fri 17 March 2023 at 9:38 a.m. EDT

The global banking system is reeling from a series of shocks over the past week, prompted by the collapse of California’s Silicon Valley Bank. It has raised fears that this is the start of another banking crisis, raising big questions for central banks as they try to fight inflation while ensuring financial stability.

What is happening in the financial markets?

Serious strains on the global financial system have become evident in the past week. In the US, the collapse of Silicon Valley Bank (SVB) last Friday was the first domino to fall, followed by New York’s Signature Bank on Sunday. Wall Street’s biggest lenders are teaming up to save First Republic Bank after its shares crashed, pumping $30bn into the bank. (£25 billion) into it. In Europe, the Swiss National Bank was forced to offer a £44.5bn lifeline. to Credit Suisse. While there were specific problems at SVB and Credit Suisse, there are signs of wider distress.

Each week, the Federal Reserve, America’s central bank, provides details of the bailout it has provided to American banks over the past seven days. In the last week, this rose from $15 billion. to $318 billion. – well over $130 billion. at the start of the Covid-19 pandemic and not far from $437bn. at the height of the banking crisis following the bankruptcy of Lehman Brothers in 2008.

So are we facing a repeat of the global financial crisis of 2008?

It is too early to say at this stage, but there is reason to hope that a repeat can be avoided. First, banks are in better financial shape than they were in 2008, when many were operating with only small amounts of capital to cover losses from the meltdown in the US sub-prime mortgage market.

Second, the entire global financial system froze in 2008 because no one knew how big the losses were and which banks were most exposed. There is still no sign of that, and banks are forced to report regularly on the quality of their asset portfolios, even under severe stress tests.

Finally, central banks such as the Federal Reserve and the European Central Bank have established lines of credit designed to help banks with cash flow problems. That said, the global financial crisis, or GFC, started on a small scale and quickly escalated. What’s more, it is clear that banks – and other financial institutions – are suffering serious losses. A lesson from 2008 is that self-confidence can quickly disappear.

Why do banks make losses?

Central banks responded to the GFC in two ways: they cut interest rates and pumped money into the banking system through the process known as quantitative easing (QE). In effect, central banks bought bonds – mostly issued by governments – and exchanged them for cash that found its way into the economy. A further round of interest rate cuts and QE took place at the start of the Covid pandemic.

Central banks have reversed course due to rising inflation. They have raised interest rates and started selling bonds. Bond prices rose as a result of the QE programs but have fallen sharply in the past year as QE has been wound down. The aggressive action by central banks has left commercial banks with large and unexpected losses. SVB had invested heavily in long-term US Treasuries, but when interest rates rose sharply, the value of their bond prices fell. When customers started demanding their money back, it forced SVB to sell bonds at a huge loss and blew a hole in the balance sheet.

What happens next?

Central banks are in trouble because there is a tension between their two main functions: keeping inflation low and maintaining financial stability. Raising interest rates and reversing QE is designed to slow growth and thus bring down inflation, but although the ECB went ahead with a planned rate hike on Thursday, the cost of doing so is that some banks are struggling to cope with the tougher conditions.

Financial markets now assume interest rates will peak faster and at a lower level than they did before the crisis at SVB blew up, and will await how the Fed and Bank of England respond with interest rate decisions next week. The reason for not raising borrowing costs further is that only a fraction of the effect of the past year’s higher interest rates has been felt so far, and that commercial banks are already reacting to the problems at SVB and elsewhere by reducing their lending. The risk of recession has increased significantly in the past week.