The Great Central Bank Dilemma

Inflation Versus Systemic Financial Risk

Where there is inflation, interest rates need to rise to slow the pace of rising prices. Right?

Well, that was the conventional wisdom until recently. But once central bankers cut interest rates to near-zero levels in the wake of the financial crisis of 2008-09, they became reluctant to raise them back to historically more ‘normal’ levels. The orthodoxy became that near-zero rates were here to stay, and once the pandemic hit home in the first quarter of 2020, the central banks cut interest rates even further.

By early 2021, however, a full year before Russia invaded Ukraine, there were signs that inflationary pressures were percolating through all of the G-7 economies. I wrote a piece here entitled The Wolf of Inflation prowls menacingly beyond the City gates in March 2021. Yet central bankers proclaimed in unison that any inflation evident was “transitory” and caused by Covid supply-chain bottlenecks, which would naturally resolve themselves in the short term.

To be correct, they should have said it was “transient”, meaning fleeting or temporary, rather than “transitory”, meaning moving elsewhere – but the word first uttered by the Federal Reserve (Fed) was repeated by both the Bank of England (BoE) and the European Central Bank (ECB). This proved the extent to which this supranational tribe of unelected potentates is in ideological lockstep.

Then came the war in Ukraine and the unprecedented spike in energy prices which precipitated double-digit inflation across Europe, although one could argue that the war was the spark that lit the flame. Inflationary pressures had been building for some time because loose monetary policy – near-zero interest rates combined with persistent quantitative easing (QE), where central banks pump money into the economy by buying government and then corporate bonds – was always going to swell asset prices. That was good news for people who own equities and real estate; but bad news for those who don’t. Income and wealth inequality has accelerated since the financial crisis – and the central bankers are partly to blame.

Last week, the BoE raised the UK base rate from 4.25 to 4.5 percent – the twelfth rate hike since December 2021. So, the base rate in the UK is now back to somewhere near its long-term average over the 329 years since the central bank was founded, of 3.5-5.0 percent. The period of interest rates of less than one percent which pertained over the 13 years between March 2009 and December 2021 was – as many of us argued at the time – a massive historical aberration which was never going to last.

Rachel Reeves MP, the shadow chancellor, tweeted last week that mortgage holders would be “wracked with anxiety” by the latest interest-rate rise. It depends on what you think is normal. In the early years of the Thatcher government interest rates reached 17 percent. The problem is, of course, that mortgage holders have got used to ultra-low rates – the new normal that wasn’t – and, in many cases, lenders have failed to stress-test the ability of mortgage holders to service their mortgages, despite perfectly predictable increases in rates.

It’s now likely that rates might rise further before they peak, especially in the UK, given the persistence of inflation. No central banker will admit that inflation is endemic – even if that is what most respectable economists now believe. The longer inflation becomes entrenched, the more difficult it becomes to dislodge. Prime Minister Rishi Sunak might just succeed in his chief objective of halving inflation from over 10 percent to five percent or so by the end of this year – or at least by Q1 2024 – but it will persist in the UK and elsewhere. This means that no self-respecting central bank can seriously talk about cutting rates. The new normal is the 329-year-old normal.

The key variable is not that interest rates will increase, but the speed at which they do so. If interest rates rise too far too fast, that risks damaging bank balance sheets and thus possibly causing financial instability as fears of bank failures circulate and then redouble. Indeed, as we know, a number of US banks including Silicon Valley Bank (SVB) and First Republic Bank have gone under of late, as well as poor old Credit Suisse which has been subsumed by its historic rival, Union Bank of Switzerland (UBS).

There has been much pondering as to which financial institution – in the US or in Europe – might be next. Even if few analysts are predicting a full-blown systemic banking crisis like the one which followed the collapse of Lehman Brothers in September 2008, the global banking system is creaking under unfamiliar stress. One thing is for sure: when the money supply contracts violently, there are casualties.

US Banks

US banks are victims of two conflating crises: a bond-market collapse as interest rates surge; and a commercial real-estate crash, given the rise of home working and the enduring effects of the pandemic. A recent Hoover Institution report deems that almost half of the 4,800 banks in the US are “burning through their capital buffers.”

The US Treasury and the Federal Deposit Insurance Corporation (FDIC) bailed out all of the uninsured depositors in SVB and Signature Bank when they collapsed in March. SVB’s mistake was to park too much of its deposits in trusty US Treasuries. The market value of these ‘riskless’ assets has been declining as rates rise. If you have to sell them to cover cash requirements when depositors withdraw funds, you incur a loss. SVB could have covered the decline in its Treasury portfolio by taking out futures contracts – but that would have just transferred the risk to the banking system as a whole. Interest-rate risk is back.

The FDIC has been generous thus far: no depositors have lost money, though bondholders and shareholders have been wiped out. But it means that, in future, it will be harder for any bank in distress to raise new equity or to find a buyer.

This is not likely to be repeated in any future banking collapse. When First Republic Bank collapsed, the FDIC took over, wiping the slate for all shareholders and bondholders. JP Morgan only agreed to acquire what was left on 1 May, after the rump bank received a $13bn public subsidy. First Republic, the third US lender to collapse in two months, had a niche business in lending to technology companies; but seemingly it met its nemesis in the commercial real-estate market.

Thereafter, the shares in Pacific Western, a Californian lender with its headquarters in Beverley Hills, had to be suspended after they fell by nearly 60 percent. Shares in Arizona’s Western Alliance fell by 62 percent, and those in First Horizon, based in North Carolina and Tennessee, by 40 percent. First Horizon was hit by the news that TD Bank, a Canadian lender, had abandoned its proposed $13.4bn takeover.

All of these banks have similar business models to the unfortunate SVB, with a high proportion of uninsured deposits. PacWest’s deposit base had declined by over $5bn to $28.2bn over the first three months of the year. Last week, the bank announced that its deposit base had stabilised. Other regional banks have become the objects of intense scrutiny such as Zions Bancorporation (Utah) and Comerica (Texas).

Real-estate loans in the US are typically on short maturities and therefore must be refinanced regularly. Borrowing exploded during the pandemic when the Fed – like other central banks – cut rates and began another QE binge. These chickens are now coming home to roost.

Market sentiment has driven depositors towards ‘too big to fail’ banks such as JP Morgan. This is causing the FDIC to skew deposit insurance premiums so as to impose greater burdens on the largest banks. Nelson Peltz, the activist investor, has warned that more regional US banks will fail unless deposit insurance rules are extended further. At present, only deposits of up to $250,000 are guaranteed by the FDIC.

On 2 May, 10 Congress members, including Senator Elizabeth Warren, signed a letter to Jay (Jerome) Powell, the Fed chairman, urging him to pause further hikes in interest rates in order to “avoid engineering a recession that destroys jobs and crushes small businesses.” In the event, the Fed raised rates by a further 25 basis points on 3 May, taking the Fed funds rate to 5.0-5.25 percent, but signalled that rates may now have peaked.

The US banking system is still much more fragmented than in Europe and Japan because of the enduring legacy of the Glass-Steagall Act of June 1933. It separated commercial and investment banking and banned inter-state banking. The Act was only finally repealed in 1999. Moreover, the Fed and the FDIC regulate banks that are “not systemically important” in a more liberal – some would say laxer – fashion.

Just after the ‘shotgun’ acquisition of First Republic, JP Morgan chief executive Jamie Dimon declared that the crisis was over. Powell endorsed this, saying that the US banking system was “sound and resilient.” We were reminded that back in March when SVB went down, President Joe Biden piped up with: “Americans can rest assured that our banking system is safe” – even though the fact that a president found it necessary to utter those words was itself concerning.

Not everyone is so sanguine about the current outlook. Robert Kaplan, a former president of the Dallas Federal Reserve Bank, thinks that we are in “the early stages, not the late stages, of a banking crisis.” Charlie Munger, Warren Buffett’s other ‘brain’, has warned that US banks are replete with non-performing real-estate loans. New York University estimates that there are $1.7trn of unrealised loan losses in the US banking system. The FDIC admits that there are $7.7trn of uninsured bank deposits.

The US Treasury yield curve is still inverted: yields on short-term bills are higher than on long-dated bonds. This suggests that the markets expect inflation to persist. It is significant that banks in Wall Street and Chicago are cutting salaries and reducing their headcounts. The banking landscape in the US is also clouded by the prospect of a US government default if the Republican-controlled House of Representatives does not permit a further increase in the federal debt ceiling.

European Banks

Some European bankers such as Frédéric Oudéa, the outgoing chief executive of France’s Société Générale (SocGen), think that there is a “fundamental contrast” between the risk profile of European and American banks.ⁱ He thinks that there are too many small and medium-sized banks in the US which are inadequately regulated. Europe has the Basel III regulatory framework; whereas, in the US, the Trump administration eased some of the stress tests required for banks with assets of less than $250bn. In particular, these institutions do not have to write down unrealised losses on their bond portfolios.

So far in Europe there have been just two victims of the current banking wobble: Credit Suisse, and the UK subsidiary of SVB which was hastily purchased by HSBC. The popular wisdom is that the deposits of European banks are less concentrated than those of US banks and are therefore less likely to suffer rapid depositor withdrawal. SVB and Signature Bank had a relatively small number of large-scale depositors in the tech sector – including many venture-capital funds. Such customers are interconnected, and once one fund smelt blood the others followed suite. This is known in the trade as a “sensitive funding model.”

It does seem that European banks are in general more liquid than their US peers. The heavy outflows experienced by Credit Suisse in its final months were mainly associated with its wealth-management division. UBS now plans to wind down much of Credit Suisse’s investment bank, with the possible loss of 17,000 jobs globally. What is troubling is that Credit Suisse’s metrics looked decent at the beginning of the year. Its capital and liquidity ratios were wholesome. But, in the end, market sentiment prevailed. Once investor confidence is lost, it is difficult to regain.

European banks are also less exposed to volatile commercial real estate than their US ‘cousins’. And yet, the share prices of European banks have been in freefall. SocGen’s share price slumped by 26 percent in March and has only partially recovered since.

Rising rates could mean that European banks can widen their lending margins. Although, in France, caps on the rate at which mortgages can be repriced – given a generally fixed-rate mortgage market – may affect banks’ bottom line. New mortgages in France are declining as compared with last year. SocGen has been able to offset these challenges with strong bond-trading revenues and reduced loan losses.

During the European sovereign-debt crisis of 2011-14, much hot air was exuded regarding the need for a European banking union. Yet there is still no Europe-wide equivalent of the FDIC. The Bank Recovery and Resolution Directive (BRRD) does not allow national governments to bail out uninsured depositors in a banking crisis. That was why many depositors lost money during the Cypriot bank crisis of 2013.

Each member of the eurozone is responsible for maintaining its own banking system – even though it cannot print its own money or set its own interest rates. Nor is there any common European debt – Germany and the Netherlands have always tirelessly resisted that one.

EU-wide inflation is down to 5.6 percent, but bank lending is contracting. Reportedly, European banks are tightening their credit criteria. The ECB is still raising rates − the last hike was by 25 basis points, effective 10 May, to 3.75 percent – and has signalled that there will be more increases to follow. Moreover, the ECB is now committed to a policy of quantitative tightening which will accelerate the decline in the overall money supply. There will be fewer euros in circulation henceforth.

This could be taking place at a moment when many of the cheap emergency loans made available at the beginning of the pandemic become due. An estimated €470bn of such loans must be repaid next month, disproportionately by Italian banks. They may indeed find alternative funding sources – but almost certainly at a higher cost, which will be passed on to borrowers.

On the plus side, non-performing loans across the EU have fallen to just two percent of total lending. Tier one capital stands at an average of 15.27 percent and liquidity ratios are generally robust. Nonetheless, Jacques de Larosière, a former chief of the IMF, at the Official Monetary and Financial Institutions Forum (OMFIF), attacked central banks for unleashing inordinate amounts of QE long after it had become inflationary.

UK Banks

Banks can profit from interest-rate increases by raising margins on loans without passing on the full increment in funding rates to savers. That is now happening in the UK.

On 2 May, HSBC reported profit before tax for Q1 2023 of $12.9bn, compared with $4.1bn for Q1 2022. HSBC’s common equity, tier one capital ratio for Q1 2023 was 14.7 percent, compared with 14.2 percent in Q4 2022. Its net interest margin – that is the differential between interest income and the cost of funds – rose by 0.5 percentage points to 1.69 percent. UK MPs accused the giant bank of boosting profits at the expense of customers.

At the same time, BoE data showed that UK depositors had withdrawn £4.8bn of savings from UK banks in March. This was considerably more than depositors withdrew in October 2008 after the collapse of Lehman Brothers and suggests that some degree of trepidation had already spread to this side of the ‘pond’.

In the UK, only the first £85,000 of an individual’s deposit is insured by the Financial Services Compensation Scheme (FSCS), an agency of the BoE. Much of the money withdrawn was moved into National Savings & Investment (NS&I) accounts – which is good news for the government, as it provides a cheap form of state borrowing. This mirrors the shift of deposits in the US out of bank deposits towards money-market funds – a trend that will force banks to increase savings rates in time.

The trajectory of UK property prices is also an important metric. The property-price crunch that many commentators have foreseen eludes us – indeed house prices in more salubrious parts of the UK are still buoyant.

Thus far, the BoE’s tighter monetary policy seems to have had scant impact on the real economy. The labour market is still tight, consumption is holding up and private-sector wages are rising by seven percent – not as much as inflation, but not much less. We are not in recession, as the Bank foresaw last year.

The quantity of money in the economy is hardly ever mentioned by the BoE these days – statistics, like hemlines, are subject to fashion. Central banks across the West are now slamming the stable door long after the inflationary horse has bolted.

The Real Masters: The Private-Equity Funds

While most eyes are on the stability and solidity of the banking sector, it is easy to miss the wood for the trees. Arguably, the principal movers and shakers in a modern economy are not the banks but the private-equity funds, which now own huge chunks of the UK economy. They are the new ‘masters of the universe’. And these entities are just as sensitive to interest-rate rises as banks.

Apparently, the best-paid bankers in Wall Street are those who are responsible for maintaining relations with asset managers and private-equity firms such as Blackstone, KKR and Apollo which are known to be the biggest fee-payers. These institutions generate huge cash flow for banks with their leveraged buyouts. The old money-spinners (execution-only bank transactions and dealing) − are not as remunerative as once they were.

I’ll have more to say about the private-equity behemoths – and the possibility of their contagion – shortly. For now, I observe that in the new capitalism the role of commercial banks seems to be not so much to provide finance to businesses, but to finance private-equity giants so that they can buy them.

Pointers For Investors

After years in which net interest margins were squeezed, now that the confected era of near-zero rates is over, there is some prospect of upside opportunity for banks. For years, banks’ return on equity has been less than their cost of capital. That cannot endure indefinitely. We might be entering a new phase where banks return as a must-have holding in any diversified portfolio – even as the minnows will be swallowed.

But for now, banks still face deposit outflows and thus rising funding costs, while the quality of their loan assets is declining, meaning that default risk is increasing. In the US, the small-cap bank stocks are most exposed to a downturn in the economy. Right now, a balanced equity portfolio should have underweight exposure to the banking sector – and especially smaller American banks.

In hindsight, the great banking wobble of 2023 will probably be seen not so much as a credit crisis but a failure by central banks to maintain long-term financial stability.

Afterword

It has been a wet, cold spring. The garden is at least one month behind: wild, if you will. There is no evidence of global warming here. Even the swifts were late, arriving in furtive pairs and then manifest yesterday, though in reduced numbers. No aerobatics from them, due to too few insects. Their inimitable ‘shriek-song’ is more muted than in previous years. I hear no scratching in the rafters, as I used to.

Oh, for some warmth, like last summer.

Listed companies cited in this article which merit analysis:

• Société Générale SA (EPA:GLE)
• JP Morgan Chase & Co. (NYSE:JPM)
• HSBC Holdings PLC (LON:HSBA)

i^ Financial Times, 12 May 2023.