The Cost of Free Money Could Be Higher Than Expected

I recently finished reading a book by Italian economist Paola Subaachi called “The Cost of Free Money.” While the book mainly discusses the adverse effects of low interest rates and unfettered capital, I couldn't help but link the common thread in the book to last week's events at SVB bank and Credit Suisse. Both cases are directly related to the low cost of capital that has shaped the world economy over the past 15 years. 

The disruptive nature of dollar flows into the less developed regions of the world when interest rates are low is the primary focus of Subaachi's book. The inflow of dollars to Latin America and Asia, for example, inadvertently boosts poorer countries exchange rates and makes trade less competitive. Government deficits rise and economic growth in these countries falls.
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When interest rates eventually rise again in the US, the poorer nations then suffer capital flight when the dollars move back home. If they’ve borrowed in dollars, which they often do, the dollar repayments become increasingly harder for the poorer countries to service given weaker exchange rates. These events broadly explain the currency crises that befell Mexico and Argentina during the 1990s and early 2000's. Today, as it so happens, the annual inflation rate in Argentina is an incredible 100%.
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The cost of free money and the effects of rising interest rates are of course being felt in the developed world today, too. The so-called “risk free” rate associated with government bonds single handedly took down SVB bank last week and planted seeds of doubt about the robustness of the entire global banking system. While the risk of default from holding US treasuries is almost zero, their values like all other bonds falls when interest rates rise. Why buy a 30 year bond that yields 1.5% when newly issued bonds with the same duration yield 3.5%? When interest rates started to rise last year, SVB got stuck in a liquidity mismatch between the declining value of its long-term assets (treasuries) and its short-term liabilities (customer deposits).

Well-managed banks avoid these mismatches by hedging their interest rate risk through swaps. A swap is a derivative investment that allows investors to ‘swap’ bonds that offer variable interest rates for fixed interest rates. When rates rise, the investor with a fixed interest swap has hedged the risk and protected his/her position against rising yields. Astonishingly, it appears that SVB didn’t buy swaps which left it badly open to a run on its deposits when word got out. Rumours are now circulating that SVB closed down its risk-management department last year, just as rates were beginning to rise.

The consensus among most analysts is that SVB is an isolated case of extraordinarily bad risk-management. The larger and systemically more important banks haven’t, we hope, been anywhere near as reckless. Indeed, in light of the ECB’s 50 basis point rate hike on Thursday, Christine Lagarde must feel quite confident too that Eurozone banks are in rude health. Increasing interest rates into a creaking financial system, however, seems like a huge mistake. The trade-off between inflation and financial stability is now becoming painfully obvious. 

While pausing or cutting rates would stoke fear and cause contagion in markets, pushing rates higher also increases the probability that further cracks in the financial system could occur. In fairness central banks are in an impossible position. Just days after the SVB debacle, news broke that First Republic and Credit Suisse also required emergency lending from their central banks. Treasuries rallied and the yield on the two year note fell to six month lows as investors fled to safety. On Wednesday, the deluge in bank stocks wiped 30% off the share value of Credit Suisse.

Unlike SVB, Credit Suisse had a healthy level of liquid assets and is also reported to have had adequate risk management measures in place too. Its problems mainly stem from regular allegations of fraud in recent years and its inability to stay out of the headlines for all the wrong reasons. Credit Suisse thus became an easy target  given the wider concerns in the banking sector. Despite good liquidity coverage ratios, the bank remains practically insolvent.

Prior to the recent decline in its Tier 1 common equity, which broadly represents its share value and its ability to raise capital, Credit Suisse passed the regulators stress tests last year with flying colours. This goes to show that bank stocks and balance sheets are not always correlated. So while banks are better capitalised since the financial crisis and can cover liabilities in a major event, vulnerabilities still remain from an attack on their share values. 

While, historically, a rising interest rate environment is usually good for bank profits, today’s interest rates reflect higher inflation caused by oil shocks and supply chains, and less so from economic growth. On the one hand, central banks have been raising short term interest rates to fight inflation and on the other hand long duration government bond yields have been in steep decline. This yield curve inversion, typically between the 2 and 10 year treasury bond, is the markets way of saying “we believe economic growth will slow and inflation will fall.” 

Banks may profit from rising interest rates in the meantime but for how long? If deposits are less 'sticky' than once believed, many smaller banks could be forced to pass on higher interest rates to their customers to avoid bank runs. Their profit margins thus get squeezed.

It’s also worth bearing in mind that a lot of the bigger commercial banks nowadays generate profits  through securitization. When a bank creates new loans it quickly sells them on to capital markets as mortgage backed securities and credit card debt. As interest rates rise, however, the value of these assets falls like all bond portfolios. A case in point is the subprime market in 2008. The Fed funds rate peaked at 5.25% in 2008 before the crash. Two years previously interest rates were just over 2%. 

For the non-bank lending sector, the rising interest rate environment could pose serious challenges too. Unlike banks who rely mainly on customer deposits for funding, non-banks rely on capital markets. Non-banks make money from borrowing short and lending long. In an inverted yield curve environment, however, their business model becomes much less profitable. Earlier this year Finance Ireland suspended its fixed rate mortgage offering for durations above 10 years due to falling long term interest rates. As funding becomes more expensive and the ability to provide profitable products becomes tougher, non-banks could suffer significant losses in the short to medium term. 
 
Since the pandemic and the changing nature of work, assets linked to the commercial real estate market are another area of concern. According to the IMF, commercial property funds held by Irish investors in Ireland are valued at approximately 40% of GDP. Roughly, this equates to €190 billion, the majority of which is leveraged debt issued by Irish banks. The banking sector, along with pensions, are thus exposed to falling commercial property values which fell 6% in 2022 and are expected to fall a further 10% in 2023.  

No one knows for sure where, when or how big the next crisis will be. From UK pension funds, banks, real estate or to a major fallout from corporate (and sovereign) debt, as long as interest rates remain elevated so too is the likelihood that something else in the economy will break.