Volker Wieland is Executive Director of the Institute for Monetary and Financial Stability at Goethe University Frankfurt.
Like the two mythical ancient monsters on the Strait of Messina, the financial crisis and high inflation are currently threatening the ship of the world economy. Odysseus followed the advice of the sorceress Circe and avoided the pull of Charybdis as much as possible. However, he came too close to Scylla, who devoured six of his companions.
Today, the most important central bankers – first and foremost Jerome Powell from the US Federal Reserve and Christine Lagarde from the European Central Bank (ECB) – are being asked to escape the pull of inflation without triggering a banking crisis.
Following in the footsteps of Circe, Lagarde explains that there is no conflict at all between price and financial stability. Higher interest rates fight inflation. At the same time, struggling banks can be helped with extensive liquidity and other instruments. Interest should therefore be the rudder to avoid the whirlpool. In addition, the ship has water cannons that keep Scylla at a distance.
However, following the recent interest rate hikes, the central banks are likely to find it difficult to maintain the necessary pace. The rapid rise in interest rates since last summer is giving the banks a hard time.
Rising yields mean that the value of bonds on balance sheets falls. The Silicon Valley Bank (SVB) had a large portfolio of government bonds. Unfortunately, these were not accounted for at the market price. In order to cushion the outflow of deposits, the SVB had to accept high losses in value when the bonds were sold. That broke her neck.
However, the interest rate risks for banks have been known for a long time. As early as 2016, for example, the “economic experts” warned that a long-lasting low interest rate policy could endanger financial stability because it drives banks to grant long-term low-interest loans and to take higher risks – which break through precisely when rising inflation rates are forcing central banks to raise interest rates quickly.
We are experiencing a crisis with an announcement
The Bank for International Settlements took the same line. So we are experiencing a crisis with an announcement. Unfortunately, the central banks did not follow the recommendations of many experts to raise interest rates early but slowly.
Instead, financial and monetary policy relied on the network of new institutions and stricter regulations created after the global financial crisis that broke out in 2007. They should ensure that banks have sufficient capital and liquidity. They also wanted to solve the “too big to fail” problem by allowing larger banks to be wound up in an emergency without contaminating the financial system. Shareholders and creditors should bear the costs instead of taxpayers.
The hectic emergency merger of Credit Suisse, threatened by massive outflows of bankruptcy, with its arch-rival Swiss UBS has shown how fragile the situation in the banking sector is at the moment. In the case of the SVB, the US government even felt compelled to protect deposits in the billions that were not covered by the deposit insurance.
Apparently, the fear of systemic effects was great. Bank shares have also collapsed in Germany. Central bankers and politicians – in the case of Deutsche Bank even the Federal Chancellor – assure that the dams from equity and other financial buffers are high enough to prevent a new crisis in the financial system.
Global Challenges – idea and regular authors
In fact, compared to the global financial crisis, significantly more precautions were taken for such a situation. But whether they are sufficient remains to be seen. One thing is clear: stressed banks limit their lending. This amplifies the effect of interest rate hikes and also slows aggregate demand.
The central banks would therefore no longer have to raise interest rates so much to get inflation under control. But tighter credit conditions can also affect aggregate supply, fueling inflation – the global economy moves between Scylla and Charybdis.
The banks need more capital
If a full-fledged banking crisis does occur, the central banks will either not continue raising interest rates or will reverse some of the increases. In the wake of the global financial crisis, the economic slump quickly stopped inflation. Against the background of the energy crisis and a shortage of workers, stagflation, i.e. economic stagnation plus inflation, could not be ruled out this time either.
One conclusion for the future is that equity and liquidity requirements for banks still need to be increased significantly if government intervention at the expense of taxpayers is to be avoided and central banks are to be given sufficient leeway to combat inflation. And next time, monetary policy will have to get the financial system used to higher interest rates earlier, but more slowly.
The author: Volker Wieland is Executive Director of the Institute for Monetary and Financial Stability at the Goethe University in Frankfurt.
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