To understand the 2023 banking crisis, look back to the 2008 financial meltdown

The solutions put in place to stabilise the financial system in the wake of the global meltdown have not protected us from the risks of damaged fiscal finances and weak growth potential
With financial confidence still fragile, the ability to cope with shocks like SVB and Credit Suisse is limited

David Brown

Published: 9:30pm, 27 Mar 2023

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New crisis? What new crisis? It’s too easy to write off the current banking crisis as just another unfortunate event in a long series of setbacks suffered by the world since the 2008 global financial crash. In truth, we still haven’t emerged from the aftershock of 2008.

The world has subsequently been battered by the pandemic, the Ukraine war, the inflation shock and the current banking crisis, but they are all genetically linked by the failure of policymakers to deal with contingent risks arising from 2008. World financial stability remains deeply challenged by weak global growth potential, compromised monetary policy and badly damaged fiscal finances, a leftover from 15 years ago.

Bank balance sheets are still undergoing repair, financial confidence remains fragile and the ability to cope with new shocks like the Silicon Valley Bank (SVB) collapse and Credit Suisse troubles remains severely limited. Global policymakers are running out of time and obvious solutions, but they need to be quick before the contagion gets out of control.

The crisis of 2008 still has a very strong resonance today. It’s not hyperinflation that we need to worry about but the longer-term danger of deflation if the world slips back into recession after central banks overreacted with higher interest rates than necessary.

Of course, you have to have some sympathy for central bankers, conflicted by the need to batten down the hatches on inflation while taking care not to upset economic confidence and market stability in the process. It’s the speed at which official interest rates have been driven higher over the past year that has done the damage.

In the rush to raise rates in the US and Europe, the central banks scored an own goal, hitting the interest-rate-sensitive components of banks’ capital and reserves, leaving potential holes in balance sheets. It was one of the main factors which brought down SVB, whose US Treasury and mortgage-backed bond holdings were hit as the Federal Reserve continued to tighten policy.

Signs explaining Federal Deposit Insurance Corporation and other banking policies are shown on the counter of a bank in Westminster, Colorado, on November 3, 2009. The US Fed’s rate hikes hit the interest-rate-sensitive components of banks’ capital and reserves, a major factor that led to SVB’s downfall. Photo: Reuters

As US interest rates rose, the market value of SVB’s prudential bond holdings fell dramatically, leaving the bank vulnerable to a run on deposits and a predatory wave of short selling by speculators.

The problem now is that it has opened a Pandora’s box of contagion risks with viral uncertainty spilling over into other banks, reminiscent of the mood of 2008. There is not a lot policymakers can do about it other than throw more money at shoring up beleaguered banks’ balance sheets and reversing the recent round of interest rate hikes.

It leaves the Fed caught between two stools, between a past obligation to rebuild its inflation-fighting credibility and a more pressing need now to shore up vulnerable global financial stability. The conflict has to be resolved soon.

Given the prevailing mood, there is reasonable justification for global interest rates to be closer to zero than the 4.75-5 per cent marker indicated by the latest US Fed funds rate.

The Fed raised rates by a further quarter of a percentage point last week, but the odds are that this should be the last move in the cycle, especially with headline inflation expected to fall in the coming months. By the end of 2023, US consumer price inflation could be close to the Fed’s 2 per target, which means interest rates have to come down soon to avoid recession.

The world’s authorities are running out of lifelines. The fiscal cost of bailing out the 2008 crash, the pandemic and the cost-of-living crisis has piled a huge lump of long term IOUs onto government finances, which will either require stronger growth, higher taxes or austerity spending cuts to cure.

According to the Organisation for Economic Cooperation and Development, pre-crash government debt levels for the total OECD area surged from 74 per cent of gross domestic product in 2007 to a peak of 130 per cent of GDP in 2020. The world cannot afford another costly banking bailout.

The pressure now is on central banks to move away from their fixation on inflation to ensuring financial stability. The world needs stronger growth, which requires a leap of faith for policymakers to open up the portals for stimulus, not policy restraint.

The last thing we need is a global recession and all the associated risks of economic pain and market meltdown. It’s time for central banks to mend their ways and turn over a new leaf.

David Brown is the chief executive of New View Economics