21 March 23
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Inflation is receding, albeit slowly, so there’s no reason to risk more financial tumult. Will the central bank see it that way?
None of the 12 members of the Federal Reserve Board’s Open Market Committee were elected to their posts. The vast majority of Americans don’t even know their names, except perhaps for the chairman, Jerome Powell.
But as they try to decide whether to raise interest rates and, if so, by how much, America’s central bankers are deciding on the fate of the American – and much of the world’s – economy.
And they’re sitting on the horns of a dilemma.
On one horn is their fear that inflation will become entrenched in the economy, requiring more interest-rate hikes.
On the other horn is their fear that if they continue to raise interest rates, smaller banks won’t have enough capital to meet their depositors’ needs.
Higher rates could imperil more banks, especially those that used depositors’ money to purchase long-term bonds when interest rates were lower, as did Silicon Valley Bank.
That means that raising interest rates could cause more runs on more banks. The financial system is already shaky.
The two objectives – fighting inflation by raising rates, and avoiding a bank run – are in direct conflict. As the old song goes: “Something’s got to give.” What will it be?
The sensible thing would be for the Fed to pause rate hikes long enough to let the financial system calm down. Besides, inflation is receding, albeit slowly. So there’s no reason to risk more financial tumult.
But will the Fed see it that way?
The Fed’s goal last week was to stabilize the banks enough so the Fed could raise interest rates this week without prompting more bank runs.
The Fed bailed out uninsured depositors at two banks and signaled it would bail out others – in effect, expanding federal deposit insurance to cover every depositor at every bank.
On top of this, 11 of America’s biggest banks agreed to contribute a total of $30bn to prop up First Republic, another smaller bank caught in the turmoil.
This “show of support” (as it was billed, without irony) elicited a cheer from Jerome Powell and the treasury secretary, Janet Yellen, who called it “most welcome”. (Of course it was welcome. They probably organized it.)
But investors and depositors are still worried.
Other regional banks across the US have done just what Silicon Valley Bank did – buying long-dated bonds whose values have dropped as interest rates have risen. According to one study, as many as 190 more lenders could fail.
On Monday, First Republic remained imperiled notwithstanding last week’s $30bn cash infusion. Trading in its shares on the New York Stock Exchange was automatically halted several times to prevent a freefall.
Multiple recent downgrades of banks by ratings agencies like Moody’s haven’t helped.
Reportedly, the Biden administration is even in talks with Warren Buffett, the chairman of Berkshire Hathaway, who invested billions to bolster Goldman Sachs during the 2008 financial crisis.
Meanwhile, on the other side of the Atlantic, the European Central Bank last week raised interest rates by half a percentage point, asserting its commitment to fighting inflation.
Yet the higher interest rates, combined with the failure of the two smaller American banks, have shaken banks in Europe.
Just hours before the European Central Bank’s announcement, the banking giant Credit Suisse got a $54bn lifeline from Switzerland’s central bank.
Yet not even this was enough to restore confidence. After a several days of negotiations involving regulators in Switzerland, the US and the UK, Switzerland’s biggest bank, UBS, agreed over the weekend to buy Credit Suisse in an emergency rescue deal.
Finance ultimately depends on confidence – confidence that banks are sound and confidence that prices are under control.
But ever since the near meltdown of Wall Street in 2008, followed by the milquetoast Dodd-Frank regulation of 2010 and the awful 2018 law exempting smaller banks, confidence in America’s banks has been shaky.
November’s revelation that the crypto giant FTX was merely a house of cards has contributed to the fears. Where were the regulators?
The revelation that Silicon Valley Bank didn’t have enough capital to pay its depositors added to the anxieties. Where were the regulators?
Credit Suisse had been battered by years of mistakes and controversies. It is now on its third CEO in three years.
Swiss banking regulations are notoriously lax, but American bankers have also pushed Europeans to relax their financial regulations, setting off a race to the bottom where the only winners are the bankers. As Lloyd Blankfein, then CEO of Goldman Sachs, warned Europeans: “Operations can be moved globally and capital can be accessed globally.”
One advantage of being a bank (whether headquartered in the US or Switzerland) is that you get bailed out when you make dumb bets. Another is you can choose where around the world to make dumb bets.
Which is why central banks and bank regulators around the world must not only pause interest rate hikes. They must also join together to set stricter bank regulations, to ensure that instead of a race to the bottom, it’s a race to protect the public.
Banking is a confidence game. If the public loses confidence in banks, the financial system can’t function.
In the panic of 1907, when major New York banks were heading toward bankruptcy, the secretary of the treasury, George B Cortelyou, deposited $35m of federal money in the banks. It was one of the earliest bank bailouts, designed to restore confidence.
But it wasn’t enough. JP Morgan (the man who founded the bank) organized the nation’s leading financiers to devise a private bailout of the banks, analogous to last week’s $30bn deal.
Confidence was restored, but the underlying weaknesses of the financial system remained. Those weaknesses finally became painfully and irrevocably apparent in the great crash of 1929.
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