As interest rates continue to rise, the turbulence on the financial markets is causing concerns for many people. While some compare it to the financial crisis of 2007 and 2008, others suggest that it’s more similar to the “Savings and Loans” crisis of the 1980s and 1990s.
During the 1980s and 1990s, more than 3,000 small banks in the US were forced to close due to the similar problem that banks faced today. Banks had been making long-term loans at low-interest rates, but as interest rates rose, those loans became less profitable. The banks were left with not enough money to sustain their operations.
Although in January 2022, homebuyers in the United States could still get a 30-year loan and pay only three percent interest, interest rates have since risen significantly. While bank customers aren’t withdrawing their money, banks are still paying low-interest rates to customers who have deposited their money with them. However, the recent withdrawal of billions of dollars from Silicon Valley Bank by some of its large customers has caused a problem.
These customers couldn’t be satisfied with low-interest rates and were well-connected. As a result, when the bank had to sell the government bonds and long-term loans to return their money, they made losses as these bonds were worth less than before. This situation shows that the increased interest rates are hurting the profitability of banks, which could lead to a crisis.
The lesson from the 2008 financial crisis is that governments must never allow a big bank like Lehman Brothers to go bust again. The big banks are now considered safe havens, and many investors are pulling their money out of small banks and lending it cheaply to the big banks. They, in turn, could lend this cheap funding back to the small banks to stabilize the situation.
The current situation highlights the importance of proper risk management for banks and shadow banks. If they have a weak system, it limits the scope of monetary policy, and central banks lose their leeway for their interest rate hikes to control inflation. Instead, monetary policy is then dominated by the financial system, which is known as financial dominance.
To stabilize the situation, central banks and policymakers must act quickly. A continued withdrawal of low-interest deposits could get more banks into trouble, which could worsen the situation. Interest rates have risen faster in recent months than at any time in the past 40 years. It was expected that a rise in rates would cause turbulence in the financial system, and the difficulties would have been less severe if central banks had tightened the reins of monetary policy earlier.
Banks need to have enough equity capital to cope with the rise in interest rates in a stable manner. To do so, central banks must prohibit money being distributed to shareholders, especially in the form of dividend payments and share buybacks. Unfortunately, this is not the case, as some banks are planning to pay large dividends, making it more likely that financial dominance will emerge.
Another problem looms in Europe, particularly in Italy, where banks hold a significant number of government bonds. These bonds have no equity capital that can be used to hedge against the risk of loss. When banks are forced to sell these government securities, they make losses, and the financing costs for some states in the euro zone also rise. This cycle could lead to a vicious circle where the risk of states not repaying their bonds increases, causing the value of the bonds to fall further, and the banks to get into even more trouble.
It is essential that central banks and policymakers act quickly to prevent a crisis in the financial system. Banks must have enough equity to cope with the rise in interest rates, and central banks should prohibit dividend payments and share buybacks. Banks must back their government bonds with equity and governments must ensure that their bonds can be repaid. If all parties work together, we can avoid a financial crisis like the one in the 1980s and 1990s.
