I am inclined to refer to an article by Nouriel Roubini* about the state of
banks operating in the United States. In his opinion “Most the US banks are
technically near insolvency and hundreds are already fully insolvent”.
In January 2022, when yields on US 10-year Treasury bonds
were still roughly 1% and those on German Bunds were -0.5%, he warned that
inflation would be bad for both stocks and bonds.
Higher inflation would lead to higher bond yields, which in
turn would hurt stocks as the discount factor for dividends rose. But, at the
same time, higher yields on safe bonds would imply a fall in their price, too,
owing to the inverse relationship between yields and bond prices.
This basic principle – known as duration risk – seems to
have been lost on many bankers, fixed-income investors, and bank regulators. As
rising inflation in 2022 led to higher bond yields, ten-year Treasuries lost
more value (-20%) than the S&P 500 (-15%), and anyone with long-duration
fixed-income assets denominated in dollars or euros was left holding the bag.
The
consequences for these investors have been severe. By the end of 2022, US
banks’ unrealized losses on securities had reached US$620 billion, about 28% of
their total capital (US$2.2 trillion).
Making matters worse, higher interest rates have reduced the
market value of banks’ other assets as well. If you make a ten-year bank loan
when long-term interest rates are 1%, and those rates then rise to 3.5%, the
true value of that loan (what someone else in the market would pay you for it)
will fall.
Accounting
for this implies that US banks’ unrealized losses actually amount to US$1.75
trillion, or 80% of their capital.
The unrealized nature of these losses is merely an artifact
of the current regulatory regime, which allows banks to value securities and
loans at their face value rather than at their true market value. In fact,
judging by the quality of their capital, most US banks are technically near
insolvency, and hundreds are already fully insolvent.
To be sure, rising inflation reduces the true value of
banks’ liabilities (deposits) by increasing their deposit franchise, an asset
that is not on their balance sheet. Since banks still pay near 0% on most of
their deposits, even though overnight rates have risen to 4% or more, this
asset’s value rises when interest rates are higher.
Indeed,
some estimates suggest that rising interest rates have increased US banks’
total deposit franchise value by about US$1.75 trillion.
But this asset exists only if deposits remain with banks as
rates rise, and we now know from Silicon Valley Bank and the experience of
other US regional banks that such stickiness is far from assured.
If
depositors flee, the deposit franchise evaporates, and the unrealized losses on
securities become realized as banks sell them to meet withdrawal demands.
Bankruptcy then becomes unavoidable.
Moreover, the deposit-franchise argument assumes that most
depositors are dumb and will keep their money in accounts bearing near 0% interest
when they could be earning 4% or more in totally safe money-market funds that
invest in short-term treasuries. But, again, we now know that depositors are
not so complacent. The current, apparently persistent flight of uninsured – and
even insured – deposits is probably being driven as much by depositors’ pursuit
of higher returns as by their concerns about the safety of their deposits.
In
short, after being a non-factor for the last 15 years – ever since policy and
short-term interest rates fell to near-zero following the 2008 global financial
crisis – the interest-rate sensitivity of deposits has returned to the fore.
Banks assumed a highly foreseeable duration risk because
they wanted to fatten their net-interest margins. They seized on the fact that
while capital charges on government-bond and mortgage-backed securities were
zero, the losses on such assets did not have to be marked to market. To add
insult to injury, regulators did not even subject banks to stress tests to see
how they would fare in a scenario of sharply rising interest rates
Now that this house of cards is collapsing, the credit
crunch caused by today’s banking stress will create a harder landing for the
real economy, owing to the key role that regional banks play in financing small
and medium-size enterprises and households.
Central
banks therefore face not just a dilemma but a trilemma. Owing to recent
negative aggregate supply shocks – such as the pandemic and the war in Ukraine
– achieving price stability through interest rate hikes was bound to raise the
risk of a hard landing (a recession and higher unemployment). But, as I have
been arguing for over a year, this vexing trade-off also features the
additional risk of severe financial instability.
Borrowers are facing rising rates – and thus much higher
capital costs – on new borrowing and on existing liabilities that have matured
and need to be rolled over. But the increase in long-term rates is also leading
to massive losses for creditors holding long-duration assets.
As a
result, the economy is falling into a debt trap, with high public deficits and
debt causing fiscal dominance over monetary policy, and high private debts
causing financial dominance over monetary and regulatory authorities.
As I have long warned, central banks confronting this
trilemma will likely wimp out (by curtailing monetary-policy normalization) to
avoid a self-reinforcing economic and financial meltdown, and the stage will be
set for a de-anchoring of inflation expectations over time.
Central banks must not delude themselves into thinking they
can still achieve both price and financial stability through some kind of
separation principle (raising rates to fight inflation while also using
liquidity support to maintain financial stability).
In a debt trap, higher policy rates will fuel systemic debt
crises that liquidity support will be insufficient to resolve.
Central banks also must not assume that the coming credit
crunch will kill inflation by reining in aggregate demand. After all, the
negative aggregate supply shocks are persisting, and labour markets remain too
tight.
A
severe recession is the only thing that can temper price and wage inflation,
but it will make the debt crisis more severe, and that in turn will feed back
into an even deeper economic downturn.
Since liquidity support cannot prevent this systemic doom
loop, everyone should be preparing for the coming stagflationary debt crisis.
*Nouriel Roubini is a professor emeritus of economics at New
York University’s Stern School of Business, the chief economist at Atlas
Capital Team, CEO of Roubini Macro Associates and co-founder of TheBoomBust.com
