Fighting inflation or saving banks?
The forced closure of Silicon Valley Bank (SVB), the staggering of the First Republic Bank and the forced takeover of Credit Suisse by UBS have dominated market events in recent days. Bank stocks around the globe went down; equity markets showed larger losses; credit spreads widened significantly. Safe investments such as government bonds and safe-haven currencies such as the Swiss franc gained in value.
There are two reasons for the uncertainty among market participants:
1. Banks are crucial to the economic activity: If the banking system falters, this has immediate and far-reaching consequences for the economy as a whole. Liquidity needs may suddenly no longer be met, loans may be withdrawn and the transfer of risk between market participants may be impaired. In addition, banks are highly interconnected, and the model of the financial system is based on the fact that investors must have confidence in the banking system. If they withdraw their money on a massive scale, even solidly financed banks can get into difficulties.
2. The SVB in particular has become a victim of the sharp rise in interest rates as a result of the deliberately chosen aggressive maturity mismatch. Its investment book has lost value, making it impossible to service the sudden and rapid withdrawal of investment funds by clients. To prevent further contagion in the banking system, the financial house was closed by order and customer deposits were fully secured by the authorities. Nevertheless, questions and fears remain about the extent to which other companies will not be able to truly absorb the rapid and sharp rise in interest rates in recent months and could run into problems.
In a form of dramatization peculiar to certain augurs, a supposed dilemma for the central banks was immediately identified: Should they continue to fight inflation by raising interest rates and thus let the banking system fall apart? Or should they support the banking system with interest rate cuts and let inflation gallop away? As a matter of fact, the market-implied expected interest rate peaks for the USD have come back significantly: from a peak of 5.7% on March 8 to currently 4.9%.
Fact is: Problems in the banking system are due to a lack of liquidity and a loss of confidence. Higher interest rates are not the cause of these problems, nor do they really exacerbate the situation. Higher interest rates are primarily used to tame inflation by making money scarcer; measures to increase liquidity – such as the current SNB liquidity line for Credit Suisse– are used to support banks and the system. The liquidity situation is only very conditionally related to the money supply.
Even if higher interest rates can tend to reduce liquidity – there is no actual contradiction or even conflict of objectives for central banks. Central banks will continue to focus on fighting inflation. Even if commercial banks may struggle with higher interest rates in some cases, lower interest rates are neither necessary nor sensible nor effective in containing any systemic problems.
