«We Should Be on the Alert for More Problems»
Raghuram Rajan, Professor of Finance at the University of Chicago and former Governor of the Reserve Bank of India, fears that the crisis in the US banking sector is not over. He explains why he thinks the stress in the financial system is an unintended consequence of easy monetary policy, and why a soft landing seems unlikely.
In the United States, one bank after another is collapsing. After the failures of Silicon Valley Bank and Signature Bank in March, another bank, First Republic Bank, had to be rescued through an emergency takeover at the beginning of May. PacWest is feared to be next. Even the shares of larger banks such as US Bancorp and Capital One are under heavy pressure.
Although things otherwise remain remarkably quiet in the financial markets, Raghuram Rajan sees no reason to sound the all-clear. «Unfortunately, the sense is that this particular phase of the banking problems is over, but I think the banking system still needs watching», says the finance professor at the University of Chicago and former Governor of the Reserve Bank of India.
Dr. Rajan knows what he is talking about. In the summer of 2005, he caused a stir when he warned against excesses in the banking system in front of the assembled financial elite at the economic symposium in Jackson Hole. He was sharply criticized back then, but today he is one of the most renowned economists of our time.
In an in-depth conversation with The Market NZZ, which has been lightly edited for length, he explains why the banking crisis is likely to continue, where the main vulnerabilities in the financial system are and why, in his view, they are a consequence of the easy money with which the Federal Reserve has repeatedly flooded the system in the past years. He also says why the risk of a hard landing for the economy is high.
«At some point, we need to pay more attention to easy monetary policy, creating the kind of financial vulnerabilities that lead to the problems we’re seeing today»: Raghuram Rajan.
Professor Rajan, the regional banking crisis in the US is dragging on. With First Republic Bank, another institution recently collapsed. How do you assess the situation?
As it was the case with Silicon Valley Bank and Signature Bank, First Republic Bank was in a very difficult situation. This was a bank in the category of the «walking wounded», it was inevitable that something would happen eventually. Unfortunately, the sense is that this particular phase of the banking problems is over, but I think the banking system still needs watching.
Why?
The recent events highlighted mid-sized banks with volatile deposits and asset problems. I think the asset problems haven’t gone away. There are still lots of losses to be absorbed on bank balance sheets, and the problem with volatile deposits hasn’t gone away either. There certainly are deposits that are looking at higher interest rates and demanding higher interest rates to stay. That means net interest margins for many banks are shrinking considerably. As a result, there will be an issue of longer-term health of the banking system, especially regarding mid-sized banks exposed to areas like commercial real estate.
Total unrealized gains (losses when negative) on investment securities either available for sale or held to maturity by FDIC insured banks in the US.
The broader question is, of course, how did we get here?
The Federal Reserve has put out a report, talking about poor bank management, but also poor supervision. However, what doesn’t get any mention is the role of easy money for over ten years. At some point, we need to pay more attention to the role of easy monetary policy in creating the kind of financial vulnerabilities that led to the problems we’re seeing today. If there wasn’t a risk of systemic issues, you wouldn’t need these bank rescues, you could just let them fail. But the fact that you don’t want them to fail is because you worry about a spread or contagion, and that contagion comes from systemic factors like monetary policy.
This past summer, you and three co-authors presented a paper at the economic symposium in Jackson Hole that warned of potential problems in the banking system regarding the reversal of QE. To what extent does this crisis feel like déjà vu for you, especially since you had already pointed out risks in Jackson Hole before the last financial crisis?
It’s not so much a déjà vu, it’s more the underlying reluctance to see monetary policy as a cause, and sort of blame it on everything else. There is this belief in academia which has percolated to the central banks that it’s possible to have a clean separation between monetary issues, which monetary policy takes care of, and financial stability issues, which supervision takes care of. The thinking is that somehow you can keep them separate. The problem, of course, is that monetary policy creates pressures that incentivize the private sector to make the kinds of mistakes that lead to systemic stress in the financial system. Then, you have a problem which leads to bailouts and so on.
What brings you to this thesis?
There were precursors of what we are seeing today, which suggests this is not a coincidence, but has a long genesis. For instance, in September 2019 all hell broke loose in financial markets when repo rates went through the roof. The repo crisis was a liquidity crisis, and because interest rates weren’t raised at that time it stayed just a liquidity crisis. The Fed came in and bailed out the system with liquidity, so we didn’t have to worry about solvency.
The next shock followed with the Covid crash in March 2020, where the Fed intervened much more forcefully.
Covid would have been a big crisis if the Fed hadn’t come in and flooded the markets with liquidity. At the same time, the federal government had to put in a huge amount of money to firms which then repaid their banks. In fact, loan losses during the pandemic were negligible relative to what was anticipated. That made us believe yet again that we shouldn’t worry about risks because eventually somebody will come and bail us out. This time, the Fed is raising interest rates at the same time as they’re withdrawing liquidity and it turns out to be a twin problem for these regional banks we’re talking about.
Why exactly?
When the Fed engages in quantitative easing, it doesn’t happen in a vacuum. For example, when the Fed buys bonds from a pension fund, it is paying the pension fund for those bonds, and the pension fund then deposits the payments into its bank account. So essentially, the Fed has taken out bonds of the private sector and replaced them with reserves and these reserves end up on banks’ balance sheets. Hence, QE not only increases the size of the central bank’s balance sheet, but also drives an expansion in the broader banking system’s balance sheet.
What are the consequences of this?
This expansion in the broader banking system’s balance sheet is funded in a very volatile way, with uninsured demand deposits. So unless the banks invest carefully and maintain a very close watch on liquidity, they can run into problems. It seems paradoxical: You’re flooding the market with the most liquid asset on the planet which is central bank reserves, but because commercial banks fund it in a particular way – by issuing demand deposits, by issuing lines of credit against the reserves – they have a lot of claims on liquidity they have to satisfy.
That is exactly what is happening today. With quantitative tightening, or QT, the Fed is shrinking its balance sheet and draining liquidity from the system.
When you reduce the reserves, these claims don’t reduce in proportion. Consequently, the system gets tighter and tighter, and that creates problems. Now, that is assuming the banks invest properly. But some of them buy long-term treasuries and similar assets which expose them to asset side risk over and above the liability side risk they already have. Probably, they have been thinking they don’t have to worry since they have invested in long-term treasuries which are perceived to be pretty liquid. But as we have seen, those treasuries can fall in value when interest rates go up, and then you have a solvency problem coupled with a liquidity problem.
Where do you think we will go from here?
Depositors have become much more mobile, perhaps as a result of recent events or perhaps more generally. Fact is, they want higher interest rates and that means the stable, low interest deposit is no longer as easy to come by for many banks. To survive, they have to pay higher interest rates. But if you’re paying higher interest rates, then you can’t fund those long-term low interest rate loans you made through the period of easy money. That’s because those low interest rate loans no longer give you enough revenue to pay the cost of your deposits. Accordingly, the worry is that going forward, a number of banks will start reporting lower and lower profits. We have to see, but there are studies showing that hundreds of banks could start reporting negative profits.
Simplistically, could we also say that the financial system has become so addicted to the liquidity provided by the Fed and other central banks that it is now suffering from withdrawal symptoms because liquidity is being drained?
That’s a good analogy: The system is addicted to easy liquidity, and if you have provided it with high levels of liquidity it gets used to the higher levels. There is sort of a hysteresis in this process: The more you feed it, the more it gets used to it, and then withdrawing from that high level becomes hard. Certainly, it’s very hard to go back to the original levels, but it’s already hard to even bring it down somewhat. That’s the experience we saw in September 2019 with the repo crisis, we saw it in spades in 2020 during the Covid crisis, and we see some evidence of that again now.
In Europe, too, the ECB has flooded the system with massive amounts of liquidity and even pushed interest rates into negative territory. Will European banks soon face problems similar to those in the US?
At least so far, it seems that the European supervisors have been paying more attention to such aspects as interest rate risk. What was made clear in the Fed’s report on its own performance is that while they recognized these risks, every time the goal posts sort of changed: When they modeled in substantial interest rates risk at a bank, the bank criticized the model and insisted that it is actually doing better, and then the supervisors didn’t necessarily insist that the bank brings the interest rate risk into line in a short period of time. It’s good that the Fed acknowledged that there were supervisory problems. But it’s not clear why basic banking principles were sacrificed - and that is something the Fed will have to think about.
Does this mean that there is less risk of a banking crisis in Europe?
It is less clear that there is a whole systemic issue. There is an issue with banks like in the case of Credit Suisse which are still struggling to find a clear business. Also, depositors become a little bit more willing to search for higher interest rates. Making money off of sleepy depositors is going to be harder and harder. That’s a potential issue even for the European banks. But I don’t think the extent of exposure on the asset side, at least from the outside, seems as dramatic.
What about risks outside the banking system?
Europe also had a massive market intervention to provide easy liquidity during the pandemic. On both sides of the Atlantic, bankruptcies sort of went down rather than up during the pandemic. And, given the size of the shock, that would suggest that there are problems stored up in the system. Whether this is a big problem or a process of adjustment, only time will tell. The clever companies used the easy money to extend maturities, raise more financing so as to build bigger buffers. Now, they can weather a recession if a recession happens or if some of the fallout from the war in Ukraine becomes tougher.
What about the less clever companies?
The real problem comes from the companies that were already at the margin and couldn’t borrow that much long-term debt. They had to borrow shorter-term debt, and that debt will start maturing soon. At that point, they have to refinance in an environment which is far less tolerant to risk than during the pandemic. So my sense is stress will creep up in the system, but it is very hard to see how much and where. As we saw last fall, the UK’s experience with leveraged liability-driven investments was a problem not many people were focused on. Similarly in the US, I don’t think there was a lot of focus on interest rate risks bringing down these banks. So when liquidity comes down, when financial conditions turn tougher, the problems sometimes emerge in unexpected places. Therefore, until we see interest rates start coming down, until we see liquidity stabilize, we should be on the alert for more problems.
So far, however, central banks are not signaling any imminent easing of monetary policy. To what extent will the banking crisis in the US affect the Fed’s efforts to bring inflation under control?
The hardest part is the last mile. We’ve already seen some of the easy gains: supply chain snarls are becoming untangled and some of the energy prices that had gone up during the early phase of the war have come down. In general, all that has been absorbed into the inflation numbers. In the US, housing has to come down, and it is likely to come down later in the year, but much of the other adjustments have taken place. Inflation is now being held up by strong services inflation, which means core inflation is stabilizing at a high level. Accordingly, the Fed needs to see core inflation come down, and this is where I think they want to see more slack in the labor market so that some of the forces pushing up wages in the service sector will soften.
What does this mean for the future course of monetary policy?
The Fed is caught in a bind. If it pauses, the market would celebrate and the Fed would not be able to finish the job. At the same time, it cannot keep hiking rates and see the system break. So the real question the Fed will be thinking about is inflation versus financial stability. Things are starting to slow in the US. But last quarter, even though growth slowed, the consumer was still quite strong. Until the Fed gets the consumer to slow down a little bit, I think they will not feel their job is done. Typically, if monetary policy is successful in bringing down inflation, it happens at the cost of perhaps a greater slowdown. Mind you, slowdowns are not easy to manage, because once a slowdown starts, it has sort of a life of its own.
However, the stock markets are apparently hoping for a mild downturn. Equities are holding up surprisingly well.
It’s interesting, if you look at the details, this is a fairly narrow market rally, largely centered around big tech companies. It’s not as if all stocks are benefitting, it’s more all this buzz about ChatGPT and generative AI is giving people a sense that big tech might have a lot more firepower. It’s entities like Microsoft, Apple and even Meta that are holding up the market. In that sense, I wouldn’t put too much weight on the stock market rally.
So how do you assess the probability of a soft landing of the economy?
With high interest rates it’s rarely a smooth landing. At this point, a soft landing seems to be a very low probability. Here’s the paradoxical thing: as the economy displays more life it becomes clearer the Fed has to do more to slow it down which then creates more of a probability that economy adjusts more abruptly.
A possible political showdown over the US debt ceiling adds another factor of uncertainty. What would be the consequences of a debt faceoff in Washington?
The debt ceiling is an issue, it could create some turmoil in treasury markets if we get to the point where the government has to prioritize expenditures. I’m sure the Treasury has been thinking of a plan B if Congress doesn’t act, but they certainly don’t want to come up with plan B and give Congress an out. So until the last day, we don’t know. I do think it’s quite important for the credit rating of the United States that there will be not even an appearance of a default. I hope that Congress does find some compromise, that sensible people from both sides, Republicans and Democrats, come together to pass a bill.
The Fed is already under heavy political pressure after the inflation debacle. What about its credibility, after it had mistakenly downplayed the surge in inflation as «temporary»?
This is par for the course, there is always political pressure on the central bank, and on the Fed more so than on any other central bank. Having been a central banker, I know that central banks don’t know everything. They know pretty much as much as smart market analysts, maybe a little more, but not a huge lot more. The transitory issue is something that will weigh on them, but these have been unusual circumstances with huge uncertainties. Certainly, they have been wrong, but I wouldn’t say that diminishes people’s beliefs about what they put foremost: keep inflation under control. And, if you look at market expectations on 5-Year/5-Year forward inflation, which is a measure of their credibility, the rate has been stuck at around 2.2% for the last seven or eight months, through all the ups and downs. So certainly, some people in the market believe that the Fed will do whatever it needs to be done. The only joker in the pack now is the financial stability issue which they also have to pay attention to.
