Opinion Global banking crisis: Weaknesses at individual institutions can still rock an otherwise robust financial sector

During the transition period from easy to tight monetary and fiscal policies, the likelihood of financial accidents is high

Potentially worrisome to central bank policymakers may be continued pressure in services inflation, excluding housing, a measure that Fed Chair Jerome Powell has said he is watching carefully.(Reuters/File)

Saugata Bhattacharya

March 18, 2023 07:34 PM IST First published on: Mar 18, 2023 at 07:34 PM IST

The risk of a financial accident loomed large in the aftermath of the coordinated, aggressive hiking of interest rates by global central banks. Analysts had been searching for risks of default in high-yield securities (junk bonds) to leveraged buyout (LBO) portfolios of banks. In the end, the accident emanated from a much simpler mistake. Not paying sufficient attention to a basic tenet of the banking business — banks need to match maturities of loans to deposits, the so-called “Asset Liability Mismatch” (ALM). Banks in the US only have about half of their total funds by way of deposits, the rest is through bonds issued to investors, which have a relatively short tenure. These shorter maturity instruments are used to fund longer-term loans to borrowers, which creates a rollover and interest rate risk for these banks in the event of sharp rate increases.

The concern arising from increasing uncertainty in the financial sector is a contagion. Depositors and investors, in times of adverse news, do not distinguish between short-term liquidity pressures, even though the intermediary might be fundamentally solvent, with good quality assets. One relatively small tremor from a mid-level US commercial bank disseminates rapidly throughout the entire global financial space, now being amplified even more by social media. The tech and financial sectors had already been on edge post the FTX bankruptcy in November 2022. News of the reluctance of a European bank’s biggest shareholder to inject further equity, coming soon after the finding of “material weaknesses” in financial reporting, was enough to unnerve investors.

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The other channel of contagion is the cross-holdings of various financial instruments. During a market freeze, even a mild one, prices become volatile and even disappear, which makes it even more difficult to value those instruments. Counter-parties decline to trade with troubled institutions, potentially further reducing liquidity.

Global regulators will do whatever it takes to ensure that volatility and the clogging of financial pipes remain relatively local and contained. One way is to become the “lender of last resort” and backstop (that is, guarantee) financial instruments. The best example was the US Federal Deposit Insurance Corporation (FDIC) agreeing to “make whole” the entire quantum of deposits at the troubled banks, over and above the insured $2,50,000 limit.

So what are the implications for monetary policy? The European Central Bank chose to raise its policy rate by 50 basis points despite concerns about banking stress. However, it did not give forward guidance on future rate hikes, unlike in the previous few meetings. Markets are forecasting that the US Federal Reserve will hike its policy rate by 25 basis points at its forthcoming March meeting.

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Central banks now face a difficult balancing act. Yet, their intent is clearly to separate the use of specific policy instruments to target different objectives which is what economic theory would suggest. The objective of cooling inflation is thought to be best achieved through the transmission of higher interest rates to borrowers, even while using various liquidity and credit support measures to stabilise the banking sector’s fragility. The ECB, for instance, offered a Euro 50 billion loan to Credit Suisse. The Fed’s balance sheet has also increased by nearly $300 billion last week, a deviation from the steady drawdown since mid-2022. This was, in part, due to withdrawals by banks from the various support facilities announced by the Fed, the FDIC and the US Treasury after the collapse of a few banks.

How will all this affect India, both in terms of growth momentum and policy response? The first question is whether all this volatility has an effect on the monetary policy committee’s rate decision at their next meeting in April? As of now, the set of high-frequency economic indicators suggests that economic activity and aggregate demand, while moderating, still remain strong. And core inflation still remains uncomfortably persistent.

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On the other hand, RBI data shows that India’s banking sector — in fact, the broader financial system — remains sound. Banks have stable, largely deposit-based funding, ample liquidity, little or no exposure to startups, and asset books have large high-quality liquid assets. Also, policy rate increases, as across the Asia Pacific region, have been smaller than in the developed markets.

As of September 2022, scheduled commercial banks were highly capitalised, with high provision coverage ratios and low asset stress. The RBI’s stress models show that even in an extreme stress scenario, a severe shock will cause bad loans to rise from 5 to 10 per cent, with the capital adequacy ratio depleting by 350 basis points — enough to absorb the shocks. Considering that the overall financial sector also remains resilient — urban cooperatives and NBFCs also have high capital adequacy ratios — a 25 basis points hike by the MPC is still probably the likely outcome.

The lesson from the latest episode of global volatility is that financial sector shocks can emerge from relatively unexpected sources and that during the transition period from easy to tight monetary and fiscal policies, the likelihood of financial accidents is high. The tightened regulatory and oversight mechanisms established since the global financial crisis of 2008, have made the financial sector by and large more robust, both through internal risk management practices as well as external supervision. Yet, idiosyncratic weaknesses at individual institutions are bound to persist and institutions will remain vulnerable to external developments. The RBI’s stringent regulatory oversight and the ongoing monitoring of banking stability frameworks and parameters should probably become a template for other banking regulators.

The writer is Executive Vice President and Chief Economist, Axis Bank. Views are personal