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Is the Recent Banking Turmoil a Blessing in Disguise?

The recent collapse of Silicon Valley Bank (SVB) has been a source of great concern and instability within the global banking system. Within investors and depositors, it has sparked fears which spread contagiously on a worldwide scale, placing both commercial and central banks in a difficult position.

SVB’s demise has largely been caused by its heavy investment in long-dated US government bonds. Recent economic conditions had a particularly negative impact on tech companies (which accounted for a large majority of the bank’s customer base), forcing them to withdraw a considerable amount of their deposits. In turn, this forced SVB to accumulate cash by selling its bonds, as it could no longer afford to wait for them to mature. However, it must be noted that bonds fall in price with increases in the interest rate and that the latter had risen significantly in recent times to combat inflation – as a result the SVB was selling the bonds at a loss and was overall incapable of accumulating enough cash to be solvent. Frightened investors and customers of the bank began to retreat their investments and withdraw their deposits simultaneously, worsening the situation and bringing the bank to collapse. Indeed, the collapse of Signature Bank immediately after was led by the fears caused by SVB’s situation, with depositors in the unaffiliated bank (also largely comprised of tech companies) withdrawing over $10 billion in deposits and making the bank insolvent instantly.

The violent takeover of Swiss giant Credit Suisse by its rival UBS that followed soon after further kindled fears of a financial crisis unfolding. Disaster struck Credit Suisse as a result of a significant slump in its shares due to its previous scandals. Although the core issues that initiated Credit Suisse’s fall from grace are pointedly different, rising interest rates and existing fears in the banking system certainly exacerbated its downfall.

This series of events has left the banking sector in disarray: investor fears have materialised aggressively, with many shares in EU and US banks plummeting down. Bank failures have created the illusion among investors that deeper issues reside in the banking system. Moreover, rising interest rates are now viewed as problematic for commercial banks, forcing central banks around the globe to carefully analyse their current approaches to implementing monetary policy.

On the bright side, the risk of this situation developing into a financial crisis is low. Lessons learned from the previous financial crisis of 2008 have ensured that, through regulatory measures, banks remain well-capitalised to avoid insolvency. Additionally, necessary action by governments and central banks is being taken to minimise any damage, whether that is through ensuring depositors that their money is safe or boosting cash flow in the banking sector. Above all, the issue that currently plagues the banking sector is nowhere near as severe or deeply rooted as that of 2008, when banks around the world had exposed each other to risky investments. Nevertheless, caution must be taken: with banks being interdependent globally, any fragility identified in one area can rapidly affect the whole system.

Having established what the current situation is and the minimal severity it holds, I argue that behind the turmoil lies a covert blessing. Uncertainty among banks has likely made them more risk-averse. In other words, they are more reluctant to hand out irresponsible loans or make ill-considered investments, which could be of great assistance in tackling the issue of inflation that many countries are currently facing.

Below is one way of illustrating and analysing this, through the IS-LM-PC model, using the UK as an example:

We start by establishing the model and the UK’s current situation. The topmost graph represents aggregate demand (ZZ) and supply (the Keynesian Cross) in the economy. The graph below shows the relationship between investment-savings (IS) and liquidity-money (LM). The Phillips curve (PC) in this model illustrates the relationship between the rate of change in inflation and output. Finally, the bottom graph illustrates the labour market – the equilibrium between the wage-setting (WS) and price-setting (PS) curve determines the natural (or potential) rate of output (Yn). In the UK’s situation, aggregate demand is relatively high, and therefore output (Y) far exceeds the natural rate of output, creating a significant positive output gap. As shown by the Phillips curve, inflation in this situation is rapidly accelerating.

A rise in the risk premium means that investment and consumption in the economy decrease, as firms are less capable of receiving loans to fund projects and consumers cannot borrow as easily to fund consumption. This is represented as a downward shift in the aggregate demand curve in the model (from ZZ to ZZ’), which causes a leftward shift in the investment savings curve (from IS to IS’) and a new equilibrium output (Y’) is reached. A movement along the Phillips curve means that the rate of change in inflation has decreased. However, this new output is still higher than the natural rate of output. This is because, I argue, the risk premium is unlikely to increase by a significant proportion, considering that regulations and government intervention have ensured most banks remain in a relatively stable situation.

With output remaining above its natural rate, inflation will continue to persist. This has indeed been the case in the UK, where inflation over the past month saw a surprise increase from 10.1% to 10.4%. Returning to the above model, to address this, the central bank could increase interest rates (from r to r’), shifting the LM curve upwards (from LM to LM’), the aggregate demand curve downwards (from ZZ’ to ZZ’’) and causing movements along the investment-savings and Phillips curves. Output is now equal to its natural rate, and inflation is now stable. Once again, the Bank of England has also recently committed to this path by raising interest rates from 4% to 4.25%, though this has been a considerably lower hike than the previous 0.5% increments. Arguably, the current banking situation has influenced the central bank’s interest rate hike to be lower than necessary.

To conclude, the current turbulent situation in the banking sector contains a silver lining that may not be obvious at first. As banks become more risk-averse due to uncertainty, their behaviour is likely to aid the central bank in tackling the current threat of inflation through limiting investment and consumption.


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