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From inflation crisis to financial crisis?

  • Central banks have the tools to deal with liquidity crises arising from rising interest rates and falling asset prices. Instead, the bigger threat is that higher interest rates produce large and simultaneous falls in asset prices that threaten the solvency of financial institutions. Most banks look better placed to withstand asset price falls than in 2007. If problems do emerge they are likely to do so in the shadow banking sector, or in economies where interest rates rise particularly sharply. 
  • We’ve covered the turmoil in the gilt market – and the implications for UK monetary policy – in a separate note, here. But the stark warning by the Bank of England that dysfunction in the bond market now poses a “material risk” to the UK economy has raised the more fundamental question of whether a steep rise in the cost of borrowing (and associated falls in asset prices) will trigger financial crises in parts of the global economy.
  • A simple framework for thinking about this is to separate problems caused by a lack of liquidity from those caused by a lack of solvency. Liquidity crises occur when financial institutions face strains on the liability side of their balance sheets (rolling over loans etc) and – in relative terms, at least – are easy for central banks to manage. While the specifics of every liquidity crisis will differ, the resolution almost always involves the central bank acting as a lender of last resort. They have several tools with which to do this, including repo auctions, lending via discount windows, and outright asset purchases. And while liquidity crises can cause turmoil in financial markets, the hit to the real economy is often limited if policymakers respond quickly. 
  • In contrast, solvency crises pose a much graver threat to the real economy. These occur when the value of an institution’s assets fall below that of its liabilities. Accordingly, they create financial losses that some part of the system then has to bear. If this happens on a large scale it can impair the entire system of financial intermediation and credit creation, which in turn can cause a sharp contraction in the real economy. Large and systemic solvency crises usually require the government to use its balance sheet to absorb the losses and recapitalise parts of the financial system. 
  • The LDI crisis in the UK is primarily a liquidity crisis – indeed, higher bond yields should improve the solvency of UK pension funds. Instead, the real danger lurks in solvency crises (or the risk that liquidity crises are allowed to morph into solvency crises). 
  • Stricter regulation and monitoring following the global financial crisis means that commercial banks are now better placed to withstand falls in asset prices and as thus less vulnerable to solvency crises. Capital buffers have improved (see Chart 1) and stress tests have been strengthened. Yet sources of financial risk have a habit of materialising in a way that is difficult to fully anticipate in advance. 
  • One new source of risk is the shadow banking sector, which by definition is shadowy and difficult to monitor. The IMF has previously flagged risks in sectors including private equity, commercial property and some open-ended investment funds. The greatest risks lie in areas where assets are illiquid and difficult to value. 
  • A second source of risk lies in the current unusual set of circumstances. Before the recent tightening cycle started, policy interest rates were 0.00-0.25% in the US, 0.1% in the UK, and -0.5% in the euro-zone. This period of ultra-low rates may have been justified initially by the need to provide emergency support to economies at the height of the pandemic, but one consequence has been to bid up asset prices across the board. Now interest rates are rising sharply from very low levels, there is a corresponding risk of large and simultaneous falls in asset prices. 
  • There are few parallels in history that can inform us (and regulators) what might come next. But the greatest risks lie in countries where interest rates are increasing most rapidly, of which the UK stands out. (See Chart 2.) (The interaction between fiscal policy and financial stability has not received much attention but is critical here – in an environment of high inflation and rising interest rates, governments have much less room for fiscal manoeuvre.)
  • We should also pay close attention to countries that have experienced large increases in house prices, notably the UK, Canada, Australia and New Zealand. (See Chart 3.) And while large lenders are typically subject to heavy scrutiny from regulators, smaller lenders (and indeed shadow banks) can sometimes slip under the radar. 
  • A third source of risk lies in what’s been happening in currency markets. In particular, the strength of the dollar may have caused problems for companies that have borrowed in dollars and don’t have a corresponding stream of dollar revenues or hedging in place. This in turn could create losses for financial institutions that have lent to these firms. 
  • One final point is worth stressing, which is that history shows that the macroeconomic damage created by financial crises can be radically different. The Great Depression and the 2008-09 global financial crisis caused deep recessions from which economies took decades to recover. In contrast, the Savings and Loans crisis in the US in the mid-1980s had a relatively modest impact on the US economy, and the macro effects of the UK’s Secondary Banking Crisis in 1973 were dwarfed by the oil crisis of the same year.
  • The key determinant is the extent to which problems infect the broader financial system and impair credit creation, which in turn depends on the overall health of the balance sheets of banks, households and non-financial institutions. As storm clouds gather over the global economy and financial system, it’s worth keeping in mind that financial and household sector leverage is much lower now than it was in 2007 in the major advanced economies. (See Chart 4.)

Chart 1: Tier 1 Capital Ratios (%)

Chart 2: 2-Year Government Bond Yields (%)


 

Sources:  Refinitiv, Capital Economics


Chart 3: Nominal House Prices (Jan. 2020=100)


Chart 4: DM Household Debt as a % of Income

Chart, line chart  Description automatically generated


 

Sources:  Refinitiv, Capital Economics


Neil Shearing, Group Chief Economist, +44 (0)7956581123, neil.shearing@capitaleconomics.com