The magic of maturity transformation is at the heart of modern economic progress. And yet, the sleight of hand that accepts a dollar in deposits and lends it out many times over is also at the heart of every financial crisis.
As the clouds lift on last month’s market turmoil, bank stock prices still reflect fears of worse to come. But better financial conditions overall suggest that fears of global cascading defaults look misplaced. We’ll see more accidents, but no systemic multi-vehicle pile-ups.
The risks are clear. Just as the changing climate has raised the risks of severe turbulence for airline passengers, so have rising interest rates created the conditions for more mismatches in assets and liabilities. Nothing surprising here after decades of declining rates drove investors to reach for yield in long-duration assets.
These risks are distinct from previous crises. During the 1997 Asian crisis, for example, current account deficits and external borrowing exposed banks to exchange-rate and funding risks. And the global financial crisis in 2008 was more of a classic case of underpriced loans going bad as U.S. housing losses engulfed securitized mortgage markets and upended wobbly financial institutions.
Today’s risks come mainly from the stress of mismatches in asset and liability liquidity. It’s precisely what you wondered about in that first introduction to fractional reserve banking. But it’s now aggravated by social media and technology that makes it easier than ever to pull your deposits without crowding around the teller counter to speak to Jimmy Stewart.
This means lots of balance sheets that will be forced to make painful and costly adjustments if they are forced to mark down even very safe holdings like government bonds to current market valuations. While many Monday-morning quarterbacks denounced the managers of Silicon Valley Bank for not hedging interest rate exposure, last year only 6% of aggregate U.S. bank assets were hedged with interest rate swaps, according to a recent study.
Meanwhile, U.S. regional banks look especially exposed to commercial real estate, which may take a long time to reprice as managers and employees radically reassess their office needs. Stress in venture capital and technology sectors will aggravate the pain.
The International Monetary Fund has also been taking a closer look at nonbank financial institutions, the so-called shadow banks that have grown from 40% to 50% of global financial assets since 2008. While asset managers and insurance companies can sometimes calm market turmoil by offering financing when traditional banks pull back, the IMF worries about the accumulation of leverage, hidden pockets of illiquidity, and unexpected spillovers.
Risks from these strains mount every day that interest rates notch higher, as they are likely to do in the months ahead as the Federal Reserve and the European Central Bank wage their final battle against inflation. Net interest margins will contract as banks pay higher interest on deposits and loan losses will start to accumulate.
But herein lies some comfort that the bumps ahead should be manageable. If rate cuts are unlikely before price pressures wane decisively, then we’re closer to the end of the tightening cycle than the beginning. Risk appetite will get a significant boost as markets become convinced that the next rate move is down.
Second, the largest banks in the U.S. and Europe still have large cushions of capital and ample pools of liquidity to see them through any further turmoil. If anything, America’s financial giants benefited from large inflows from depositors at smaller regional banks. European banks have little exposure to commercial real estate and boast nonperforming loans near record lows.
Finally, last month’s bank failures may have been less of a surprise than the rapid and vigorous response by regulators. No one had ever seen a deposit run as rapid as the $142 billion that would have evaporated from the balance sheet of Silicon Valley bank had the FDIC not intervened. And intervene it did.
Perhaps the most reassuring part of the recent crisis was the Fed’s timely announcement to backstop all deposits at failed banks and offer others funding against collateral at par value. There are plenty of questions around whether oversight should have been tighter or whether broad backstops encourage risky behavior. But in assessing the next risks to the economy, such measures go a long way to eliminating the great duration mismatch—at least for banks.
Naturally, there are no guarantees against future calamity. A system that allows lending out the same dollar again and again will unravel collapse whenever confidence starts to wobble. But the end of the tightening cycle, the resilience of the largest financial institutions, and the responsiveness of regulators should keep financial accidents isolated. And the magic of maturity transformation will power the next recovery when it comes.
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