After the Easy Money: A Giant Stress Test for the Financial System

Five weeks after the collapse of Silicon Valley Bank, the financial world is uncertain. The question on everyone’s mind is whether the financial stress seen in North America and Europe is a temporary blip or a sign of worse things to come. At the same time, investors, savers, and mortgage borrowers wonder when the central banks in advanced economies will change their monetary course, with inflation still rising.

The Relationship between Price Stability and Financial Stability

The financial crisis at SVB highlights the potential conflict between price and financial stability. When inflation is significantly above the central bank’s target, typically around 2%, banks and other financial institutions can face liquidity crises. Therefore, the central bank must balance the twin objectives of economic and price stability.

In the US, the Federal Reserve has to balance the objective of price stability with the goal of maximum employment. The choices made by central banks will affect personal finances. If inflation remains high, those who invested in safe bonds for their retirement could see themselves in further pain. If the central banks fail to engineer a soft landing for the economy, investors in riskier assets such as equities will be affected. Homeowners looking to refinance their loans over the coming months could also see their mortgage costs increase if the Bank of England tightens its monetary policy.

The Bubble Bursts

SVB was the 16th largest bank in the US and found itself with mainly uninsured deposits that far exceeded lending opportunities in its tech industry stamping ground. It purchased medium and long-dated Treasury and agency securities without hedging against interest rate risk to invest the surplus money. The sharp rise in policy rates over the past year pricked the bubble, depressing the value of long-dated bonds. Once depositors lost confidence in the bank, they could no longer hold on to the securities until maturity.

The fear extended to Signature Bank in New York, which was overextended in property and increasingly involved in crypto assets. Some 90% of its deposits were uninsured, compared with 88% at SVB. As failures of risk management and a series of scandals at Credit Suisse caused deposits to strip away, fear soon spread to Europe. The Swiss authorities quickly brokered a…

Related Facts

• The collapse of Lehman Brothers in September 2008 was one of the triggering events for the Global Financial Crisis.
• The US Federal Reserve raised interest rates three times in 2017 and still has a monetary policy of normalizing interest rates and reducing its balance sheet to pre-crisis levels.
• The European Central Bank has kept its refinancing rate at 0% and is currently engaged in a bond-buying program to stimulate the Eurozone economy.

Key Takeaway

The collapse of SVB is a sign that the financial system is under stress. As a result, investors, savers, and borrowers are questioning the future direction of monetary policy, which central banks must execute carefully to balance the twin objectives of financial stability and price stability.

Conclusion

In conclusion, the financial stress seen in North America and Europe is a big stress test for the financial system. However, if central banks make the correct decisions and balance financial stability and price stability, we can avoid a repeat of the Global Financial Crisis that happened in 2008.