Banks cannot liquidate their long-term assets quickly enough
The banking sector is one of the most critical components of any economy. Banks provide the vital function of taking deposits from savers and lending the funds to borrowers over long periods. This franchise model relies on two critical ingredients: earning a profit by charging higher interest on long-term loans than paying on short-term deposits and trust in the viability of the bank. However, this model has come under severe strain in recent years due to high inflation, making the traditional banking model loss-making and raising questions about the assets of some banks’ worth if sold now.
One of the most significant challenges banks face is the inherent instability caused by the mismatch in the duration of loans and deposits. Banks cannot liquidate their long-term assets , such as held bonds and loans that interest are at a loss, quickly enough when many depositors withdraw at once. Even safe banks, with ample liquidity and capital, risk collapse when trust evaporates and depositors withdraw en masse. This loss of trust in the banking system can have significant consequences, not just for the affected bank but for the wider economy as well.
2008 financial crisis highlighted the systemic risks of a banking crisis
The recent issues surrounding Credit Suisse and Silicon Valley Bank (SVB) illustrate this point. Credit Suisse is subject to more stringent regulations and oversight than other banks, and SVB was compliant with liquidity and capital regulations. However, when trust in the solvency of a bank goes, its franchise may crumble quickly, and depositors at other banks start worrying about the safety of their deposits.
The 2008 financial crisis highlighted the systemic risks of a banking crisis, leading to significant regulatory changes to prevent a repeat of the same. Banks are now more heavily regulated and have more capital, which gives them greater ability to absorb losses than they did in 2008. Banks have also been stress-tested to withstand significant losses in the value of their loan portfolio.
Despite these measures, bank runs and bailouts are still prevalent. Regulators can address trust issues by providing large, potentially limitless, liquidity to solvent banks that have suffered from an erosion of trust. Over the weekend, the Federal Reserve and other US regulators provided a large amount of liquidity to US banks, preventing a potential collapse.
Regulators can address the trust issues
This action can have a large effect on the target that the Federal Reserve has set with 2% inflation. The last CORE CPI in February came in at 6% showing that the increased Rate hikes are clearly showing their effects. However since March 7th the Fed Balance Sheet has increased by 300 billion Dollars. In Addition Jerome Powell confirmed at federal hearings in the past week that the Fed will keep the rates higher for longer, rather than a soon to come rate drop that some economists said was coming.
President Joe Biden spoke on Monday in front of cameras.“This is an important point: No losses will be borne by the taxpayers,” he vowed. President Biden noted that the cost will be financed by fees paid by other banks into the Federal Deposit Insurance Corporation, or F.D.I.C. What he did not mention was that a separate loan program that the Federal Reserve has opened to help keep money flowing through the banking system will be backed by taxpayer money. In a statement on Sunday, the Fed said it “does not anticipate that it will be necessary to draw on these backstop funds.”