Rates turmoil strikes financial system
The spike in interest rates over the past couple of years has transformed the banking landscape and placed immense pressure on individual institutions, leading to dramatic rescues in the US and Switzerland, and raising the dual spectres of systemic failure and a credit crunch.
Since late 2021, the world’s major central banks have been engaged in a fight against runaway and persistent inflation. This has comprised an extended cycle of coordinated rate hikes led by the Fed in the US – the most aggressive of the developed market central banks, having hiked its base policy rate by 475 basis points in just over a year.
End of low rate era
Financial markets and industry had become accustomed to an era of extraordinarily low rates maintained by monetary authorities in response to the Global Financial Crisis (GFC) of 2007/8. For some sectors, this radical change to a high interest rate regime poses significant – and in some cases existential – challenges.
Nowhere is this challenge more pronounced than in the banking sector. For well over a decade the sector was beset by low rates, which translated into low net interest rate margins and stagnant profitability for the sector. While rising rates have been positive for profitability, they have also caused significant declines in the value of banks’ bond holdings held as assets on their balance sheets (given the inverse correlation between bond prices and yields).
The effect of this has been to generate substantial unrealized losses on US banks’ securities holdings. The most extreme case was Silicon Valley Bank (SVB), which had taken considerable risk by parking large sums of cash in risk-free but high-duration (and therefore interest rate-sensitive) US Treasuries and in riskier agency mortgage-backed securities (MBS). Prior to the turbulence, SVB had a headline Tier 1 capital ratio of 12 %, but the unrealized losses on the securities it held effectively wiped out its capital.
Record deposit outflows
Similar problems elsewhere in the US banking system prompted a run on some smaller banks, with record deposit outflows into money market funds leading to the collapse of three regional banks within days. The prospect of an ever-widening run and a systemic crisis led to calls for the US government to guarantee uninsured deposits (above the standard USD 250,000 deposit insurance).
Swiss bank bondholders get burned
One notable feature of the rescue was a CHF16 bn ‘bail-in’ of AT1 (additional tier 1) instruments. Finma invoked “extraordinary public support” as justification for the bail-in. However, the writing down of the banks’ so-called AT1 bonds to zero while retaining shareholder value at CHF3 bn broke with convention regarding the hierarchy of payments in the event of a restructuring or liquidation. This controversial measure could well lead bank bondholders to demand higher coupons in future, increasing bank funding costs and in turn depressing lending.
This episode has highlighted a number of issues, including some apparently unresolved ones relating to the GFC and the post-GFC regulatory framework.
Differences between US and European bank regulation
The banking sector difficulties also highlight the contrast between the regulatory frameworks in the US and Europe.
The US regulates banks according to categories set by the Fed that correspond to size. Category 1 is for the largest banks, or so-called Globally Systemically Important Banks (G-SIB). Category 2 is banks holding assets in excess of USD700 bn. Category 3 is those with assets above USD250 bn, while banks with assets below the Category 3 threshold belong to Category 4 or the so-called “Other Banks” category. Banks at the Category 3 level and below have, since 2019, been allowed to opt out of the various stress tests and other supervisory measures required of larger banks, including a requirement to include unrealized losses (such as those triggered by the recent spike in interest rates) in their capital calculations.
This exemption followed the rolling back, in 2018, of parts of the Dodd-Frank Act that had been enacted in 2010, aimed at addressing the problems exposed by the GFC. The exemption meant that SVB, for example, could mark its bond holdings at their amortized acquisition cost rather than at fair value. The Dodd-Frank measures now look set to be reinstated in response to the recent turmoil.
The turmoil has exposed the US banking sector’s greater vulnerability to interest rate risk versus the European sector, reflected in markedly higher unrealized losses on held-to-maturity (HTM) securities as a percentage of tangible book value (TBV). The European sector looks healthier on other metrics too. For example, a sample of leading US and European banks at the end of 2022 showed a liquidity coverage ratio (LCR) of 165% for the European sample (the mandatory level is 100%) compared with 118% for the US sample.
[Inflation targeting – What it is, and has the 2% goal run its course?]
Central banks retain anti-crisis tools
Nonetheless, the Federal Reserve and other central banks have been decisive in their deployment of a range of tools to safeguard the global financial system in the aftermath of 2007/8. Balance sheets are stronger all round. More stringent capital requirements have reduced bad loans in European banks by two-thirds over the past 10 years. Loan-to-deposit ratios in US banks have fallen by 25 percentage points to 70% since 2007/8. Quantitative easing, forward guidance and subsidized loans to banks all form part of central banks’ anti-crisis arsenal.
For the time being, following the decisive bank rescues in the US and Switzerland, fears of systemic risk appear to have been assuaged. Concerns over the potential stress on the financial system from rising rates may give pause to central banks as they fight inflation. However, with any declaration of victory in that fight still looking premature, the prospect of more destabilizing credit events remains real.
Intuition Know-How has a number of tutorials related to the content of this article:
- Market Risk – An Introduction
- Market Risk – Management
- Market Risk – Measurement
- Bank Balance Sheets
- Basel III – Pillar 1 & Capital Adequacy
- Basel III – Pillar 2 & ICAAP
- Basel III – Pillar 3 & Risk Reporting
- Monetary Policy Analysis
- Global Financial Regulation
- US Regulation
- European Regulation
