Economists at the International Monetary Fund (IMF) believe that the financial storm has subsided — but they have their reservations: it’s a claim made timidly as the economists cross their fingers and warn about possible risks, challenges and scares. The financial instability is “contained,” says Pierre-Olivier Gourinchas, the Economic Counsellor and the Director of Research of the IMF. “It’s not 2008,” adds Tobias Adrian, the Financial Counsellor and Director of the IMF’s Monetary and Capital Markets Department, in reference to the year when the global financial crisis broke out.
The banking turmoil caused by the collapse of Silicon Valley Bank and Signature Bank in the United States, and the takeover of Credit Suisse in Europe — which was the first failure of a global systemically important bank since the 2008 global financial crisis — was bad news for the economy. There is no doubt that it impacted the financial sector, and while the IMF believes that it is likely to slow down growth, the worst-case scenarios have not materialized. “The forceful response by policymakers to stem systemic risks reduced market anxiety,” states the IMF in its Global Financial Stability Report, presented Tuesday in Washington.
According to the IMF, “the fundamental question confronting market participants and policymakers is whether these recent events are a harbinger of more systemic stress that will test the resilience of the global financial system — a canary in the coal mine — or simply the isolated manifestation of challenges from tighter monetary and financial conditions after more than a decade of ample liquidity.”
The IMF report says that the financial system is stronger and more resilient thanks to the regulatory changes approved following the 2008 financial crisis, but raises concern about the weakness of some entities and the shadow banking system.
Risks have increased with the rapid rise in interest rates to contain inflation. The common adage on Wall Street is that the Federal Reserve increases rates until something breaks. “Historically, such forceful rate increases by central banks are often followed by stresses that expose fault lines in the financial system,” Tobias Adrian explains in more academic terms. The devaluation of the Mexican peso in 1994, the Asian financial crisis in 1997, the dot-com crash in 2000, the collapse of the LGTM fund in 1998 and the subprime mortgage crisis are just a few examples.
Differences with 2008 financial crisis
But according to Adrian, while the banking turmoil has raised financial stability risks, its roots are fundamentally different from those of the global financial crisis. “Before 2008, most banks were woefully undercapitalized by today’s standards, held far fewer liquid assets, and had much more exposure to credit risk,” he states. “In addition, there was excessive maturity and credit risk transformation of the broader financial system, high degrees of complexity of financial instruments, and risky assets predominantly funded by short-term loans. Troubles that began at some banks quickly spread to non-bank financial firms and other entities through their interconnections.”
“The recent turmoil is different,” continues Adrian. “The banking system has much more capital and funding to weather adverse shocks, off balance sheet entities have been unwound, and credit risks have been curbed by more stringent post-crisis regulations. Instead, it was a meeting between the steep and rapid rise in interest rates and fast-growing financial institutions that were unprepared for the rise.”
The IMF argues that financial conditions have tightened less than might have been expected at the onset of the storm. Although bank share prices have fallen, the stock market has hardly been affected and the slight increases in the credit spreads of some companies have been offset by the fall in interest rates in the markets. Investors are confident that there will be fewer official rate hikes, and that this turmoil will do some of the work of the central banks. The IMF warns, however, that if this scenario does not play out and inflation remains high, there may be further rate hikes that catch investors by surprise.
In the report, the IMF sates that any lack of supervision and regulation must be addressed immediately — a warning that appears to be primarily a message for the United States, but extends to many other countries. To contain the risks to financial stability, adequate minimum capital and liquidity requirements are essential, even for smaller entities that, individually, are not considered systemically important.
Prudential banking rules should ensure that banks hold capital to address interest rate risk and to protect against hidden losses that could materialize abruptly in the event of liquidity shocks, the IMF argues.
If the turmoil in the financial sector were to have serious repercussions for the economy as a whole, policymakers may have to adjust monetary policy to support financial stability. In that event, says the IMF, authorities must clearly communicate their determination to return to tackling inflation as soon as possible, once financial strains subside.
The IMF sees another lesson in the recent financial storm: “That funding can disappear rapidly amid widespread loss of confidence. Shifting patterns of deposits across different institutions could raise funding costs for banks which could restrict their ability to provide credit to the economy.”
“The recent banking turmoil also demonstrated the growing influence of mobile apps and social media in spreading sudden financial asset allocations. Word of deposit withdrawals spread globally at lightning speed, potentially signaling that future banking stress may spread faster and be less predictable,” adds Adrian.
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