Tensions in the financial system: bankruptcy or recession?
Tensions in the financial system have kept the markets on tenterhooks in recent weeks. The demise of individual banks has focused attention on the possible immediate negative consequences of a crisis in the banking system: If confidence is lost, banks could get into difficulties. Due to today’s strong international interdependencies, this can lead to the contagion of other financial institutions and thus have a decisive negative impact on the development of the economy as a whole.
These immediate consequences are often associated with longer-term negative implications due to the banks’ restricted room for maneuver, possibly for years to come. After years of liquidity abundance due to monetary support measures, the past year brought a significant rise in interest rates – and that in a historically short period of time.
There are three aspects to this development:
– In the context of the repeated liquidity glut of recent years – starting with the financial crisis of 2008 and ending with the support measures in the context of the global Covid pandemic – the downward trend in yields accelerated sharply. This liquidity was absorbed by commercial banks and manifested itself in inflated bank balance sheets.
– Not least due to regulatory requirements, the stock of bonds on bank balance sheets thus also increased significantly. In general, the maturity profile and hence also the average index duration of securities have gradually increased over the past decade as a result of low interest rates.
– The historically aggressive interest rate hikes in recent months have led to sharp losses on fixed-income securities due to the inverse relationship between interest rates and valuations. The valuation changes are also visible on bank balance sheets, where horrendous losses have accumulated, albeit unrealized so far.
Accounting logic allows banks to write down bonds that are to be held to maturity on a straight-line basis. This means that such bonds are not carried on the balance sheet at the current lower market value, but according to their cost price. The sales and book values thus show a clear discrepancy.
As explained in our blog article of March 22, this is not a problem for the time being. As long as there is no excessive withdrawal of money – i.e., as long as confidence in the banks continues to exist – these theoretical losses will not be realized. It becomes critical as soon as depositors’ confidence in the banking system in general or in individual institutions in particular wanes.
Smaller withdrawals can be absorbed by liquidity held in reserve. However, if the outflows due to a panic-like crisis of confidence exceed the proportion of highly liquid positions, banking institutions must sell the loss positions. Despite the regulatory capitalization requirement, the losses realized in this way can deplete equity and thus impair the bank’s ability to survive. The immediate problem in such a situation is thus the higher sensitivity of the banking system at a level of confidence. However, the problem does not so much describe the lack of solvency of banks as the lack of short-term availability of liquidity.
The real problem lies in the limited room for maneuver of the banks, which find themselves restricted in their ability to lend and provide liquidity – even for years to come due to the sometimes long fixed interest rates on the assets. The banks either have to realize losses or restrict their activities. The former leads to potential bankruptcies, which could shake the entire financial system. The latter represents a not insignificant impediment to overall economic development. Neither of these is a very enlightening perspective…
