When you don’t know what you should be more afraid of

Lehman Brothers employees in one of its offices on the day of its bankruptcy in 2008. James Leynse (Corbis via Getty Images)

We were talking along these same lines, just a week ago, about how low tide brings up sunken ships, and that the market’s volcanologists have been looking for hidden vulnerabilities in the market for a few months. You don’t have to look any further. The risk did not arise from the real estate sector, nor from venture capital, nor from shadow banking. It came from a bank located in the most dynamic and envied conurbation in the world and which, perhaps for this reason, disregarded the minimum criteria of banking prudence and common sense. Analysts are now looking with concern at indicators such as the OIS spread, that is, the premium that the market demands for lending money to banks (in the US) compared to depositing it in Treasury bills.

Comparisons with 2008 are not entirely accurate, because history rhymes rather than repeat itself. With the scant information we have now, there are three key differential elements compared to 15 years ago: the authorities’ learning curve, time and inflation. If in 2008 the authorities’ decision to drop Lehman Brothers exacerbated the problems exponentially, in 2023 the Fed has tried to close the contagion channels as quickly as possible. That is an advantage.

As for the temporary variable, normally the pressure on interest rates takes time to be transferred to the real economy. The speed with which the Silicon Valley case has emerged is more due to poor management and regulatory laxity with this part of the market than to a systemic problem. But this is bad news: problems should take longer to arrive.

On the contrary, the third card, the inflationary card, is the most complex. In 2008 the Fed lowered rates from 5.25% to 0% and the ECB from 3.25% to 0.25%. Today, with runaway inflation, and linked more to demand than to supply, the central banks’ ability to maneuver is limited, at least on paper. Until Thursday, the risk of the banks was asymmetrical and, set to fail, they preferred to do so excessively, and cause an unnecessary weakening in the economy in order to anchor inflation. The specter of the financial crisis leaves a new balance of risks, as monetary tightening raises the risk of a financial crisis.

The financial tightening that will follow, except for an unexpected turn, due to bank distrust will do part of the job of raising interest rates. But, in any case, the conflict between the two main mandates of central banks is served: price stability and financial stability.

The economic panorama is full of ghosts, even having overcome with some solvency an autumn of 2022 that was expected to be catastrophic due to inflation and a winter in which rationing or power cuts in Europe were seriously considered. The danger now takes the form of an inflation that seems impossible to contain, each day more fragmented into different categories and less dependent on energy. And with structural elements in its favor, mainly the primacy of short supply chains and the impact of the energy transition. The consensus of the analysts is that a stage of inflation awaits us closer to 3% than to 2%. The problem, more than the rate itself, is the persistence of this inflation and to what extent it is introduced into expectations and conditions the decisions of economic actors. But more ghosts lurk, in particular the geopolitical one, with derivatives that oscillate from a commercial iron curtain to an eventual confrontation between nuclear powers.

Returning to finances, fear of fear itself, a historic expression coined by Franklin Delano Roosevelt in his 1933 inauguration speech, sums up a bank run better than any analysis. If fear and distrust settle in the markets, they take whatever comes their way, since the financial world itself is based on the belief that debts are almost always repaid and safe assets are really safe. Without it, the risk control formulas are worthless.

Now, complacency should be as scary as panic. We still do not know to what extent Silicon Valley Bank’s practices are an isolated case or in the US there are more non-systemic entities (on paper, the systemic ones are supervised). We also don’t know the ultimate extent of Credit Suisse’s problems. Assuming the market rides out this wave of trouble, the biggest risk may be assuming that the demons have been cast.

All factors are interrelated. The convoluted language of central bankers blurs the fact that lowering inflation by raising rates is something of medieval medicine; it is about voluntarily causing a recession. Paul Volcker’s shock doctrine in 1982, with rates at 20%, caused more corporate bankruptcies than the great financial crisis of 2002. Perhaps causing a recession by raising rates to lower inflation is redundant if a financial crisis in budding can do this very job. These are the tricky waters that central bankers will have to navigate today and in the coming months.

For banks, the panorama has changed radically in just one week. The foreseeable rise in financing costs (already sensitive in hybrid instruments or debt of lesser priority), the need to preserve liquidity buffers and a foreseeable greater prudence in granting credits or the endowment of provisions (whether this prudence voluntary or required by the supervisor) is putting an expiration date on the stage of soaring margins unleashed by the rise in rates. It remains for the sector to weather a déjà vu from 2008 with better wickers and a supervisor under notice. It’s not little. But as finance gets more complex and interesting, banking gets more boring.

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