Credit Suisse collapse: The collapse of two mid-sized banks in the US does not portend a hard landing or a tipping point

A “soft-landing”, namely, that a further few rate hikes by the US Fed would be sufficient to cool the economy and the labour market given time, and bring down inflation to an acceptable level with a mild recession, was still the consensus view. However, with the economy and labour market showing remarkable resilience despite nearly 5 percentage points of interest rate increases over less than a year — the most aggressive since the early 1980s — the risk was rising that the Fed might have to tighten policy more belligerently and engineer a vicious recession to tame inflation.

Since we typically tend to fight the last battle, which in this case was the global financial crisis, the focus was on the quality of credit, and we were surprised that household and corporate balance sheets were not showing any cracks. This was largely because of relatively low private-sector debt in the US. In the aftermath of the 2008 global financial crisis, much of the increase in debt has been by the government and the central banks in the US and other developed markets. During the pandemic, these governments added to the already high debt burden by providing unprecedented financial support, which has not been fully spent. As a result, households and corporates have been able to absorb the sudden and large increases in interest rates much better than in other business cycles.

But the cracks were forming elsewhere. Not in the quality of bank loans but in the valuation of investments in long-term bonds that had been increased significantly by some banks in the last few years as they searched for higher returns in a zero-interest world. Most of the long-term investments were done when interest rates were much lower. So as interest rates rose, not only were these investments making less than deposit rates, but their value also fell. Consequently, the losses to these banks had mounted to such high levels that to survive, they needed a fresh injection of capital. Once this came to light, depositors fled, and bank runs ensued.

This is broadly the story around the collapse of the two banks in the US. A natural question to ask is: Why wasn’t this detected earlier? First, as mentioned previously, the market’s focus was elsewhere – on the quality of loans and not on the valuation of bond holdings. Second, because of legislative changes in 2018, smaller banks (those with less than $250 billion in assets) were more loosely regulated. Bigger banks, on the other hand, were more regularly and closely monitored (including by the market) and where internal risk management, therefore, was much stronger. Can the problem spread? The government and the regulators have taken several measures to provide liquidity to such banks. The stigma of seeking public assistance is also less than during the global financial crisis. So hopefully, good judgement will prevail and the stress will be contained. It is important to keep in mind that the small and mid-sized banks only represent a small fraction of the US banking sector and even a smaller portion of the overall financial market that includes non-bank institutions, many of whom are several times larger than the biggest banks.

The problem surrounding the collapse of Credit Suisse is different as the bank has been struggling to restructure for a long time. Elsewhere in the European Union, regulations are differently applied than in the US and regulators have extended substantial forbearance over the valuation of assets for a long time. This extensive forbearance is unlikely to be removed any time soon. Among emerging markets (EMs), the situation is also different. Because of their history of frequent financial crises, banks in EM are supervised more closely with stricter regulations and regulators typically have ready facilities to provide liquidity to banks. These facilities as well as regulatory forbearance were vastly expanded during the pandemic and many of them remain in place. That said, virtual banking and non-bank financial activity has been rising in the last few years. These entities are less strictly monitored and pose a risk but are not sufficiently large to be systemic like traditional banks.

All that said, has a switch been truly flipped? Prima facie, central banks face the policy dilemma of easing on rate hikes to safeguard financial stability only to exacerbate inflationary pressures. So far, they have not shown any signs of taking their foot off the brake (last week the ECB raised rates aggressively despite the collapse of Credit Suisse). While a soft landing might conjure an image of a smooth glide to lower inflation, it inevitably breaks things on the way: Households get bankrupt, firms foreclose, and banks collapse. It is just that the damage is limited. The collapse of two mid-sized banks in the US does not portend a hard landing or a tipping point. Instead, it appears to be the start of the process by which interest rate hikes first slow credit, then the economy and eventually, inflation. As they are supposed to do. The battle to tame inflation is far from over in the US or elsewhere. Central banks will turn more cautious. But they will continue to tighten monetary policy where needed, while providing liquidity to safeguard financial stability. This is the separation principle on which central banks have been operating for more than two decades. It is unlikely to change.

The writer is Chief Emerging Markets Economist, J.P. Morgan. Views are personal