Can the financial system have undisclosed hazards?


Status: 03/21/2023 2:22 p.m

After the Swiss bank bailout, the excitement on the markets has subsided. The state-orchestrated takeover of Credit Suisse and the rapid central bank intervention calmed investors – for the time being. But worries remain.

By Bianca von der Au,

A tremor has shaken the banking world. After the rescue of the stumbling Credit Suisse in Switzerland over the weekend and the rapid reaction of Western central banks, investors seem to have calmed down again for the time being. At the start of trading on Tuesday, bank stocks clearly lead the DAX and Eurostoxx. After almost two turbulent weeks on the stock exchange, investors have regained confidence in local financial institutions.

The opinion seems to be gaining ground that the collapse of two regional banks in America and the former second largest Swiss bank are special cases with homegrown problems. And yet there are isolated cases that point to weaknesses in the system, believe some experts on the matter.

Record debt and rising interest rates

Probably the most prominent example is the Harvard economist Kenneth Rogoff. In an interview with the “Handelsblatt”, he is surprised that the global economy did not experience a systemic financial crisis last year – in view of the steep rise in inflation and interest rates: “If interest rates remain stubbornly high during a recession, there are huge problems as public debt has risen to record levels during the ultra-low interest rate era.”

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It currently looks as if Germany and the USA are scraping past a recession – i.e. a long-term decline in economic growth. But debt levels in many countries are at record highs. Debt in the USA has more than tripled since the 2008 financial crisis, and in the euro zone it is twice as high as in 2008. This should limit the scope for many states to provide emergency aid in the event of a crisis – especially since the interest rate hike by the central banks is also more expensive for states makes to go into debt.

Bet that interest rates will remain low “forever”.

What is decisive, however, is the ratio of debt to gross domestic product, i.e. to the economic power of a country. Banking professor Christina Bannier from the University of Giessen gives the all-clear for Germany and the euro zone: “As long as the economic development bears the debt burden of the states – and that’s what it looks like at the moment – there are hardly any immediate effects to be expected.” Especially since a large part of the national debt is in the hands of the European Central Bank (ECB) and does not directly burden the banking sector, the scientist said

However, there could definitely be indirect effects, as economist Daniel Stelter analyzes in his podcast “Beyond the obvious”. According to the economist, many financial market participants have bet that interest rates will remain low “forever”. And that bet no longer works with the unexpected return of inflation. “That means everyone who has made a long-term commitment with their investments, and who do so in part through loans, comes under pressure.”

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Which sector will it hit next?

At the moment, nobody knows exactly which sector it could hit next. “It can be commercial real estate, but it can also be hedge funds or venture capital fundraisers. Or start-ups that have a real valuation without ever having made any money. Their founders may have taken out a loan on these values, which are now dropped,” says Stelter “And if that all starts to slip, you’ll have a chain reaction.” Loan defaults would be the result, which in turn could affect individual banks.

Harvard economist Rogoff emphasizes in the “Handelsblatt” that the stricter regulation for the core areas of the banking industry has reduced the risks. But that doesn’t apply to other areas. Private equity firms that have borrowed heavily to purchase real estate are under pressure. Rising interest rates coupled with falling commercial real estate prices can become a problem. Economist Stelter puts it this way: “I think the big risk is different than in 2008: After more than ten years of the policy of cheap money, we don’t know where the money is. We only know that the amounts are gigantic.”

More US regional banks could wobble

In view of the strong regulation after the financial crisis, most experts, including expert Bannier, currently see no new banking crisis looming. Deposits are quite stable, especially at many German banks. “Typical depositors at savings and credit unions don’t withdraw their funds when the first dark clouds appear,” says Bannier.

However, certain risks still exist for the regional banks in the USA, said market observer Robert Rethfeld from Wellenreiter Invest tagesschau24. “At the moment we are seeing depot outflows from the regional banks to the big US banks. And if this trend continues, then we have a problem in the USA: then the US regional banks, which grant a large part of the loans – including business loans in the USA – no longer fulfill their function.” This could lead to a recession, which is why the US Federal Reserve must make it clear that the deposits of smaller banks are also protected. According to the Wall Street Journal, US Treasury Secretary Janet Yellen is planning to take appropriate steps.

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With the recent turmoil in the banking sector, all eyes are now on the Federal Reserve. There is growing hope that the United States Federal Reserve will end the interest rate hikes earlier than originally thought – and thus ensure further relaxation on the financial markets.

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