Freedom

Story by Matthew Lynn

Depositors can’t get their money out. Payrolls might not be met next weekend. And small companies, especially in the fast growing technology industries, might soon face closure as their assets are frozen. There will be a lot of nervousness when the financial markets open on Monday morning following the collapse of the Silicon Valley Bank in the United States and the decision by the Bank of England to take control of its London arm.

In reality, that is more than justified. There is a real risk of a full blown bank run. Central banks will have to move quickly and decisively to stop the situation spiralling out of control. And yet they also need to learn the lessons of 2008 and 2009, the last time the financial system was in this much trouble. Depositors should be protected. But bondholders and shareholders should be left to look after themselves. And, just as importantly, there should be no return to the easy money of the last decade. Otherwise we will have learned nothing from the crash of 2008 and 2009 – and risk repeating all the mistakes from last time around.

If anyone thought that we could gracefully exit from more than ten years of near-zero interest rates, unlimited amounts of printed money, and double-digit inflation, without any form of pain, they have just had a very rude awakening. Over the weekend, Silicon Valley Bank was forced to close after what appears to have been a very old-fashioned bank run. Amid nervousness about the losses it had suffered on its bond holdings, customers, in this case mostly tech companies, rushed to get their money out. 

Once that starts, it is almost impossible to stop. By Saturday morning, the American regulator, the Federal Deposit Insurance Corporation, had taken control. Anyone with cash in the bank will be able to draw up to $250,000. Over on this side of the Atlantic, SVB’s London arm will be put into insolvency. Depositors will be protected up to £85,000, with the rest made up, if possible, by liquidating assets.

The markets are going to be jittery when they open on Monday morning, and rightly so. This is the worst bank failure since 2008, and we all know what happened then. Just as worrying is that it comes on the back of a string of ‘accidents’ in the financial system. 

In the cryptocurrency sector, always likely to be where the most extreme risks were taken, the digital bank Silvergate ran into trouble last week, and, of course, it is only a few months since the exchange FTX crashed spectacularly. Likewise, in the UK last autumn, the LDI crisis blew up in the wake of a disastrous mini-budget, threatening huge losses among the pension funds, and forcing the Bank of England to step in with emergency liquidity to keep them afloat (and, as it happens, taking down the unfortunate Liz Truss’s government as collateral damage). 

Each collapse can be explained on its own. But they all have a common thread. In the background, central banks, led by the Federal Reserve, have been rapidly raising interest rates, and unwinding, and in some cases even reversing, quantitative easing. The easy money era was being brought to an end. The result? A collapse in bond prices. That caught out SVB, with huge losses on its portfolio. It caught out the pension funds, with LDI’s that assumed bond yields would never rise. And the draining of liquidity, and the return of genuine yields on real assets such as Treasury bills, crashed the price of flimsier alternatives such as Bitcoin, triggering the crisis at FTX. The circumstances varied. Yet in each case, the tightening of monetary policy was the root cause. 

Will it spread? That will be the big question everyone will be asking on Monday, and through the rest of the week. The answer will depend on how quickly, and decisively, central bankers move to calm nerves, and to show that they have learned the lessons of the last major crash. In truth, it is not going to be easy. 

In the past, there would have been a simple way out. The Fed, the Bank of England, and the European Central Bank could announce an emergency cut in interest rates and pump a few hundred billion of extra liquidity into the system. That is what Ben Bernanke, the Fed chair at the time of the last crash, or indeed Alan Greenspan, would have done. Bond prices would rally, and the banks would have spare cash and that would fix the problem. This time around, with inflation already running out of control, that is simply impossible. To cut rates and print more money now would be to guarantee hyper-inflation, with horrific consequences for every developed economy.

Instead, they only really have one option. Depositors have to be protected, and with public funds if necessary. If you have money in the bank you need to be able to get it out. Anything else guarantees a full-blown collapse in confidence in every form of financial institution, and very quickly in paper currencies as well. But unlike 2008 and 2009, the banks themselves should be closed. If bondholders and shareholders lose their shirts, then that’s just bad luck. We can’t return to bailing out failed bankers all over again. Even more importantly, we can’t return to easy money to paper over the cracks in the system. A decade of that was more than enough. 

It is going to be a high-wire act that will require huge amounts of skill to pull off. The Fed is lucky to have the hugely experienced Jerome Powell in charge, and well into

his second term, and if anyone can reassure the markets he can. It is less lucky in having the hapless Joe Biden in the White House. If anyone can make a mess of it, he will. 

Likewise, in London Rishi Sunak, with a background in banking, will be well aware of the risks that have to be managed, but Andrew Bailey has been useless as Governor of the Bank of England, and could easily fail this test. Can policymakers restore confidence in the markets, prevent bank runs, and keep up the fight against inflation all at the same time? Just possibly. But as the Duke of Wellington might remark, it will be a very close run thing – and no one would count on success right now.