Silicon Valley Bank will not be the last: The risk of a banking crisis is extremely high

The global financial system is facing increasing risks and challenges as interest rates begin to rise, and government bond prices fall. This situation has been fuelled by excessive leverage, record debt levels, and decades-long cheap money policies. As central banks struggle to balance inflation control and financial stability, economies worldwide may face significant disruptions and crises in the near future.

The risk of a banking crisis and bank runs has risen to its highest level since 2008. Falling bond prices and massive debt levels in the economy mean that the collapse of a Silicon Valley bank is unlikely to be the last.

Last week, Silicon Valley Bank (SVB) in the US collapsed, which was the largest bank crash since the collapse of Washington Mutual during the 2008 financial crisis. On Sunday, Signature Bank, which primarily funded cryptocurrency-focused companies, was also shut down. The US government intervened, and deposits of both banks were guaranteed.

This week, Swiss bank Credit Suisse also came into the spotlight – over the past decade, the bank has had several problems and changes in management. On Wednesday, major investor Saudi National Bank announced that it no longer plans to invest money in the bank. They own nearly 10 percent of Credit Suisse. The stock fell nearly 30 percent on the news.

Insuring against Credit Suisse’s insolvency became significantly more expensive this week. Based on short-term insurance pricing, at one point traders estimated the probability of Credit Suisse’s insolvency at nearly 30 percent. For the second-largest Swiss bank, this is very significant.

Let’s not forget that Lehman Brothers was not the first bank or fund to collapse in 2008. The collapse of investment bank Bear Stearns was similar and occurred six months before Lehman. True, regulators did not want Bear Stearns to go bankrupt, and it was sold to JP Morgan. Now, there are talks about Credit Suisse being taken over by Switzerland’s largest bank, UBS Group.

Central banks in a difficult situation

Although poor risk management played a significant role in the collapse of Silicon Valley Bank, it can be considered the first victim of the Federal Reserve’s aggressive interest rate hikes.

The system is heavily leveraged, and it was naive to think that removing liquidity so quickly would not cause any problems. Now central banks are in a difficult situation. Just a couple of weeks ago, aggressive interest rate hikes were expected to continue, but now the situation has changed dramatically.

On the one hand, inflation remains high, and interest rates should continue to rise. On the other hand, there is an increasing risk that raising interest rates further could cause problems for some banks or other financial institutions. The more incidents, the greater the panic, and the more people and investors’ trust in the system will erode.

From there, a liquidity crisis in the financial sector can develop very quickly – this is a situation where companies, financial institutions, and investors simultaneously find themselves without enough money to meet their obligations. If another major bank falls, we may already reach a situation where people start withdrawing money from banks en masse.

This leads to a domino effect, where the worst-case scenarios are widespread collapses of banks and the financial system or very rapid inflation. Everything in the financial system is strongly interconnected – if something happens to a major fund or bank, others that have lent to them are immediately at risk.

The problem is in the bond market

In the case of SVB’s collapse, it was notable that the bank did not hold complex and exotic derivatives. These derivatives caused all sorts of horrors during the 2008 financial crisis. Instead, the bank held US government bonds and high-rated mortgage-backed securities (MBS), considered very safe.

However, bond prices have started to fall due to aggressive interest rate hikes, which means their value in the balance sheets of various financial institutions is declining. The same happened with SVB, whose asset side shrank. The value of assets held by all other banks holding US government bonds is also shrinking.

It is no secret that falling prices of Western government bonds can cause serious problems in the financial system. Last fall, British pension funds barely survived, experiencing payment difficulties due to falling government bond prices. As usual, the central bank came to the rescue and patched up the situation (temporarily).

The snowball keeps growing

Temporary solutions, however, are not permanent. While it is possible that central banks’ tools can delay dealing with the underlying problems, over time, this becomes increasingly complicated. By now, we have reached a point where we cannot resolve these fundamental problems in the economy without significant pain. And that pain is being postponed at all costs. The snowball keeps growing.

These problems include excessive leverage in financial markets, record debt levels of companies and the public sector, artificially inflated stock prices, market distortions, and misallocations of capital. These, in turn, are the results of nearly 15 years of ultra-cheap money policies and money printing. These two have been made possible by a debt-based monetary system, where currencies are not backed by anything.

Why is there no easy way out of this situation? Two things – the long-term decline in interest rates has reversed, while high inflation is long-lasting. If we lower interest rates back to zero, inflation will spiral out of control. If we keep interest rates high, we risk financial system collapses and economic crises. Soon, reality can no longer be avoided.

The long decline in bond prices has begun

Since 1980, interest rates in the US have been falling, which has helped to service the ever-growing debt burden and keep the entire financial system functioning. Government debt has grown rapidly in both the US and other countries, but the interest paid on that debt was decreasing.

In our opinion, interest rates are now rising in the long term due to the rapid inflation of this decade, which also means the reversal of the 40-year uptrend in government bonds. This happened in 2020 when, for example, the yield on 10-year US government bonds fell to 0.5 percent.

Problems will not only arise in the financial system but also for countries themselves. In the US, interest payments on government debt rose sharply in the last quarter of the previous year, accounting for 17 percent of government revenues. As the bond downturn cycle continues, this percentage will increase, and one doesn’t need to be an economist to understand the unsustainability of the situation.

Now, bond prices are falling, undermining the balance sheets of banks holding them. We will continue to see how the reversal of such a massive market (the bond market) that has lasted for decades will shake the financial system and countries as well.

The current state of the financial system highlights the delicate balance between inflation control, financial stability, and economic growth. With the reversal of long-term trends in interest rates and government bond prices, it is crucial for policymakers to recognise and address the underlying problems to prevent systemic collapses and economic crises. The road ahead may be difficult, but taking appropriate measures and fostering cooperation among global economies is essential for ensuring a more stable and sustainable financial future.