Are we on the verge of a new global financial crisis?

In March, financial turbulence was triggered in the United States with the collapse of three regional banks (Sivergate, Silicon Valley Bank and Signature) and the spillover effect to Credit Suisse in Europe.  These crashes, so far, by no means imply a systemic banking crisis. About three banks a year have collapsed on average since 2015 in the U.S. And during the financial crisis of 2008–2010, for instance, 322 banks crashed.  

But the episode triggered alarms that prompted rapid withdrawals by depositors, and a sharp plunge in bank valuations. To understand the fears about a potential systemic crisis, it is worth analyzing the specifics of this credit cycle.   

The expansionary phase of this cycle was unusually long and lax, reminiscent of the extraordinary policies of low rates and quantitative easing to halt the collapse of payment systems during the 2008–2009 financial crisis and, subsequently, to shore up the recovery of economic activity.  

The outbreak of the pandemic reversed the process of monetary policy normalization a decade later. Thus, between 2020 and 2022, the FED doubled the size of its balance sheet and slashed interest rates to all-time lows between 0 and 25 basis points.  

The reversal stage of the cycle, triggered by the rebound in inflation to double-digits, unseen in the last four decades, has also been unusually rapid and sharp, with an interest rate spike of 475 basis points over the course of a few months.  

Perhaps the most notorious case of this financial turbulence in the U.S. was Silicon Valley Bank, specialized in the technology and startup segment.  Between 2019 and Q1 2022, SBV deposits tripled, totaling USD 198 billion, amid the most widespread abundance of liquidity.

SVB's excess deposits were channeled into the purchase of U.S. Treasury bills and collateralized mortgage-backed securities, in the context of less than proportional loan growth. This is unusual for the banking business.  

While treasury bills are regarded as one of the safe haven assets par excellence—the risk of default at maturity is almost non-existent—this does not mean that valuation of the securities does not fluctuate throughout the economic cycle with interest rate variations. 

This was precisely one of the factors behind SVB’s crash. Around 50% of its assets were treasury bills. The rapid rise in interest rates generated cumulative valuation losses on these assets in the order of USD 16 billion by September 2022.  

But for those losses to materialize, another factor came into play. Around 90% of SVB deposits exceeded the USD 250,000 threshold covered by deposit insurance.  

With the accumulation of asset valuation losses that eroded the backing of deposits and the lack of coverage for deposits that were mostly uncollateralized, panic set in and sparked the run on the bank. The ease of electronic withdrawals ultimately precipitated the bank's collapse. On March 9, people withdrew USD 42 billion, almost a quarter of SVB total deposits. That is half a million dollars per second.

Ultimately, SVB was intervened by the Federal Deposit Insurance Agency (FDIC) on March 10. In order to prevent panic from spreading to other financial institutions, authorities acted quickly and decisively. 

First, the liquidation of Silicon Valley Bank, Signature and Silvergate (the three failed banks) was announced, with their assets being transferred to a larger bank. Second, the FDIC and the Department of the Treasury announced the use of a systemic risk exception measure to fully protect all depositors of the three banks, including those with deposits above USD 250,000 not covered by the deposit insurance. Depositors were bailed out completely, but the bank shareholders were not. Third, the Fed offered a funding program to any bank facing liquidity problems, with lines of credit for the face value of the securities they may hold. The Fed also offered to extend dollar liquidity globally through swap lines.  

The measures succeeded in restoring relative calm to the markets, which made it easier for the Fed and the European Central Bank to continue the cycle of interest rate hikes in the weeks following the episode.   

What was the role of regulation and oversight in all this? Regulation is supposed to make banks more resilient to the credit cycle, discouraging excessive risk-taking during expansionary phases and compelling banks to maintain adequate liquidity levels to cope with stress situations. 

Following the 2008–2009 financial crisis, the U.S. implemented stricter lending standards for banks under the Dodd-Frank Act. This included the adoption of the Basel III criteria, and the creation of the notion of “systemic bank,” which would undergo stress tests. 

The upshot is that large U.S. banks are now better capitalized and have larger liquidity buffers than they did before the 2008 financial crisis. Thus, the largest institutions weathered the turbulence without major pitfalls.  

But that was not the case across the banking system. In 2018, cautious regulation was relaxed for medium and small banks. That category includes the 3 banks that failed in March. Each for idiosyncratic problems. 

 In the case of SVB, inadequate management of interest rate risk (and the lack of a risk officer for more than one year as an aggravating factor). Signature and Silvergate were highly exposed to the volatility and risk of cryptocurrencies. There remains a high level of uncertainty as to the vulnerability of the remaining banks to liquidity and solvency issues that could trigger a systemic crisis. 

For example, although the liquidity of the banking system is high, it is asymmetrically distributed. There is migration of deposits from medium-sized banks to large banks. Thus, the risk of further liquidity crises in other banks persists.  

On the other side of the Atlantic there is also concern. The forced sale of Credit Suisse to rival UBS was in response to a sharp run on deposits in the wake of the U.S. crisis. Apart from the materialization of the interest rate risk, however, Credit Suisse had been experiencing problems and triggering alarms.  

This saga has once again highlighted the tension in the conduct of monetary policy, in terms of the balance between inflation containment and financial stability risks. Thus far, central banks have chosen to continue raising rates, and at the same time, there is talk of changes in regulation and liquidity mechanisms to handle episodes such as the recent one.  

This will be possible as long as a systemic scenario does not materialize, forcing central banks to halt rate hikes to ensure financial stability. After all, with no financial stability, there is no way to devise monetary policy.   

Faced with continued high uncertainty, banks are preemptively tightening credit conditions while private sector confidence has waned. This in itself is skewing the weak global growth outlook for this year downward.  

A deeper and further-reaching financial crisis would undoubtedly upset the soft landing scenario—inflation control with moderate growth—pushing the world into another recession.  

It is extremely difficult to forecast the onset and timing of a financial crisis. Bank weaknesses are sometimes identified too late or, as was the case in March, the fires are successfully contained.  

But it is equally hard to imagine that, in a highly indebted world, rising interest rates do not cause accidents along the way. Accidents will happen. We just do not know their magnitude, potential for spread, or whether they can be contained before a new global crisis occurs.