international analysis and commentary

Three early lessons from the latest bout of financial markets turmoil: banks and beyond

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Today a bank can suddenly go bust having invested most of its money in the safest financial assets on the planet.

Let that sink in for a moment.

It is a delicate juncture in financial markets. I think the financial system is in a much more robust position than in 2008, so I remain optimistic. But the current turmoil holds three very important lessons that we should all take to heart — especially policymakers.

 

First: don’t give up your day job

Silicon Valley Bank (SVB) fell victim to an old fashioned bank run. It was nothing like 2008: there was no fancy financial engineering, no precarious pyramid of leverage. People talked, depositors got worried and rushed to withdraw a disproportionate amount of deposits all at once.

Faced with such a massive withdrawal, in the good old days, a bank would have failed because its assets would have been mostly long-term corporate loans and mortgages, which it could not redeem at short notice.

Ironically, SVB was in a much stronger position, in theory: its assets consisted mostly of long term Treasury bonds and highly rated mortgage-backed securities — “agency” securities, i.e. those of Fannie Mae and Freddie Mac. Exactly the kind of assets that regulators and policymakers highly recommended.

Following the global financial crisis, regulators have pressed and incentivized banks to hold reserves in the form of High-Quality Liquid Assets, with government bonds and agency bonds at the top of the list. SVB obliged.

Those bonds have virtually no default risk (high-quality) and can be easily and quickly sold at the going market rate (liquid) — but at a heavy loss, as SVB found out, because of the significant increase in interest rates needed to fight inflation.

SVB is at fault for not hedging its interest rate risk. But what happened to bank supervision?

The regulators somehow missed a risk that (a) is a classic, plain vanilla banking 101 risk; and (2) is a risk that they themselves engineered, first by pushing banks into government and agency bonds and then by raising interest rates. Nothing here was unforeseen. The weakening of Dodd-Franks banking regulations in 2018-19 played a role, as it allowed SVB to fall under the “systemically important” size threshold that would have imposed tighter scrutiny. But that’s a lame excuse for ignoring an obvious risk in a top-20 US bank that attracted plenty of attention through its extremely fast growth. SVB’s CEO was on the Board of Directors of the San Francisco Fed since 2019 — don’t they have a water cooler?

These are the same regulators who have been worrying loudly about climate risk, equity and inclusion. Always do your day job first.

 

Second: Every policy action causes an equal and opposite distortion

The past fifteen years have seen a litany of unprecedented policy interventions. Repeated and increasingly creative rounds of quantitative easing; zero or negative policy interest rates; various targeted lines of credit to support specific industries or offset the higher credit risk of specific countries (in the Eurozone); blanket shutdowns of economic activity; direct government payments to households and businesses.

 

Read also: The euro and the dollar

 

Behold the results: unprecedented volatility in the yields of benchmark bonds; high and persistent inflation; and a missing labor force in major developed economies. The latest gyrations in government bond yields in the US and Eurozone have been dizzying, but the US Treasuries market, the most liquid in the world, has displayed extreme volatility for an extended period already. Financial markets have been flying blind: the massive interventions of central banks have completely distorted the price signals of benchmark market assets. Financial markets now struggle to refocus their attention on to market fundamentals — resilient economies, hot labor markets, high wage growth and inflation — and away from central bankers of a long-established dovish reputation. This latest round of banking troubles has brought investors back into comfortably familiar territory: the idea that central banks will again lower rates and provide liquidity to underpin asset values. As if those policies have not done enough damage already.

The market economy has its faults, but it remains an impressively effective mechanism for allocating resources and boosting living standards. We tamper with it at our own peril.

 

Third: see the whole board — take a systemic view of incentives, trade offs, unintended consequences

Every major policy measure seems to have been taken in isolation, looking only at one specific concern at a time. Credit markets are seizing up — let’s flood the system with liquidity. Deflation concerns — let’s pledge zero interest rates for the foreseeable future. Climate change — let’s discourage investment in fossil fuels. Covid-19 — let’s shut the economy and pay people to stay home.

The more our economy becomes interconnected, the less we seem to think about the ramifications and unintended consequences of major policy moves. We have become ever more reluctant to think in terms of trade offs. We pretend that we have a range of costless solutions at our disposal. Most policymakers and economists dismissed the idea that persistently loose macro policy could cause either inflation or financial instability. And here we are with high inflation and bank failures. Public health experts dismissed the idea that Covid-19 shutdowns could risk lives, not just save lives. We ended up with spikes in excess mortality beyond the Covid-19 impact.

 

Read also: Deglobalization or Slowbalization?

 

We desperately need to recognize that life is made of trade offs and incentives. In this recent discussion, my friend Ed Powell makes the case for what value based optimization: a framework to think clearly and systematically about what we are trying to achieve, how we are willing to trade off different outcomes and risks against each other. It is important for policymakers, business leaders and every one of us. It is more relevant than ever.

 

Parting thought

I remain optimistic that we will successfully navigate this new round of financial turmoil; partly because some of the safeguards that regulators put in place after the global financial crisis worked well, and we should give them credit.

But if we do not take a completely different approach to tackling macro economic problems, a new major crisis is only a matter of time. And it will be another crisis of our own making.