How fragile our financial system is is currently being shown to us like a textbook: The Silicon Valley Bank and other US banks are going bankrupt, the ailing Swiss bank Credit Suisse is being taken over by UBS in a rush, and the stock markets are collapsing massively. Within a few days, the fear of another banking crisis is back to a level that was scarcely imaginable two weeks ago.
The central banks of the USA and Switzerland jumped to the side of the ailing institutions with emergency loans and guarantees. They are not entirely uninvolved in this development: the turnaround in interest rates in the USA and Europe due to inflation that was far too high has meant that securities that commercial banks hold in large quantities on their balance sheets, such as government bonds, lose value.
Banks must absorb these losses with their own capital and may also have to sell securities before maturity at a loss; it can happen that individual banks slip into insolvency.
Knowing that banks never hold enough liquidity to be able to pay off all bank deposits, such a situation can escalate into a “bank run”. Everyone wants to withdraw their deposits before others do. Once such herd behavior has started, even a solvent bank can be driven into ruin – and illiquidity turns into insolvency in no time at all.
Once distrust has spread, the banks also lose trust in one another. They are no longer willing to lend each other money in the interbank market.
It is correct that the ECB is sticking to the primacy of price stability
But how should a central bank behave when it is faced with high inflation on the one hand and bank balance sheets that have come under pressure on the other? The markets were therefore eagerly awaiting the interest rate decision by the European Central Bank (ECB) last week.
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Is it bowing to the stress in the banking sector and raising interest rates less than indicated given inflation developments, or is the primary goal still to contain inflation?
In this area of tension, the ECB initially maintained its primary focus on price stability with its sharp increase in key interest rates by 50 basis points. This commitment to fighting inflation is good for the ECB. Their tightening of monetary policy, which has often been criticized as too late, had noticeably damaged their credibility.
But what happens when the panic in the financial sector spreads to the euro area? In addition to ensuring price stability, it is the task of the ECB – albeit only of secondary importance – to contribute to the stability of the financial system.
The ECB was granted independence to fulfill its primary task of maintaining price stability, but not for its financial stability and bank bailout tasks.
As long as there are no clear risks of recession due to the turbulence, the ECB does not have to and should not deviate from its previous key interest rate policy. It has other monetary policy tools at its disposal to prevent a systemic banking crisis and should communicate this clearly to the public. The ECB can provide banks with as much money at fixed interest rates as they ask for via open market operations, thereby counteracting liquidity bottlenecks in the banking sector.
It is not the ECB’s primary task to bail out banks and ensure financial stability
Should individual banks nevertheless experience payment difficulties, the European System of Central Banks, as the lender of last resort, can offer them emergency liquidity assistance. However, a troubled bank does not have a claim to this – on the contrary, each national central bank decides whether and in what amount emergency loans are issued.
The European System of Central Banks should stick to this “constructive ambiguity” despite any panic on the financial markets in order to prevent banks from neglecting their risk management with the prospect of a central bank that can always rescue them.
The ECB was granted independence to fulfill its primary task of maintaining price stability, but not for its financial stability and bank bailout tasks. Even if the ECB can be the rescuer of the crisis thanks to its powerful monetary policy tools and its ability to create money, it is far from the only actor with responsibility.
And that’s a good thing, lest it become hostage to the needs of the banking sector and blur the focus on price stability. Rather, the governments of the member states and other European institutions and bodies are also responsible for maintaining financial stability, and they also have the necessary democratic backing for potentially loss-making rescue measures.
The authors:
Kerstin Bernoth is Deputy Head of the Macroeconomics Department at the German Institute for Economic Research (DIW) Berlin and a member of the Monetary Expert Panel of the European Parliament.
Sara Dietz is a lawyer at Hengeler Mueller and a member of the European Parliament’s Monetary Expert Panel.
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