Black swan event in West takes flight, but impact lingers

The recent events concerning First Republic Bank, Silicon Valley Bank and Credit Suisse are cautionary tales for the financial sector. SVB, for example, had not been making bold moves but was dragged down into the mire due to floating losses and term mismatches, especially related to bond holdings. As for Credit Suisse, its risky operations had proved to be beyond advisable levels, leading to a near black swan event — a rare but extremely negative occurrence that is difficult to predict.

However, despite the turmoil in the banking sector, the European Central Bank and the Federal Reserve of the United States have continued to raise interest rates under pressure from high inflation. Fed Chairman Jerome Powell said in late March that he had fully assessed the possible credit tightening caused by the banking turmoil, which in turn affected demand, employment and inflation, and decided to raise interest rates by an additional 25 basis points and keep the end rate rises unannounced at a time when the impact of credit contraction cannot be accurately quantified.

The ECB is in a similar situation. Explaining the reason for the 50-basis-point rate hike, ECB President Christine Lagarde said that core price pressure remains strong, and so does wage pressure in the eurozone. Economic growth is faced with downside risks, and inflation may rise further.

Since the outbreak of the COVID-19 pandemic, the Fed's moves have been showing an overreacting is better than doing less strategy. In early October 2020, fearing deflation, Powell said that monetary easing was better because the recovery would be stronger and faster, even if actual policy action exceeded what was needed. When August 2022 rolled in, regarding monetary tightening moves, Powell also repeatedly stressed that it's better to have more action than less, arguing that excessive tightening can be used to support the economy with policy tools — as was done in the early COVID-19 days — and that if too little is done, inflation becomes entrenched, and it will need to tighten again in the future, with the cost of employment being higher.

It should be noted that there is always a lag effect from monetary policy to the real economy. By the time it becomes clear that something is wrong, it may be too late. However, at present, high inflation and low unemployment in the US are obvious and financial stability risks are behind the curtain, as if there is no problem to fix. Therefore, while engaging in the fight against inflation, the Fed can only hold its ground by maintaining the credibility of its monetary policy.

Lessons should be learned

Looking at the turmoil in the European and US banking sectors, be it US regulators or Swiss authorities, they have indeed taken some measures, which to some extent helped curb the spread of risk in the short term. But the root cause of the risk has not been eliminated. To have a clear mind about how things came to the current pass, it's important to understand the following five causative factors.

First, in the case of relatively resilient inflation, the EU and US central banks continued tightening moves and the floating losses of bonds kept causing headaches for holders. On the balance sheet of SVB, bonds have a duration of 6.2 years and the average yield is about 1 percent. One could dream of having inflation fall to a certain extent and that would make the yield of US Treasury bonds fall below 2 percent. Otherwise, those bonds will always be faced with floating losses.

For many savings account holders, if they have a chance for 3 percent or 4 percent returns from assets of money market funds, it will be difficult to stop the transfer of deposits, thus weighing more on banks. According to a recent calculation by several professors in the US, due to the government bailout during the crisis, bank deposits grew rapidly, but the amount of deposits not protected by mandated protections increased by 41 percent compared with the end of 2019. And once there are runs on banks, as many as 186 small and medium-sized banks will be at risk.

Second, in the case of monetary tightening, asset prices will not perform very well over the short term. Despite adjustments made last year and the risk asset rebound at the end of last year, overall it was not very optimistic. Prudent investors will naturally choose to hold risk-free assets, such as short-term US Treasury bills, rather than investing in equities and bonds, which creates a situation that would still put pressure on shadow banks and vehicles, such as hedge funds.

Third, amid monetary tightening, especially when the past long-term "low growth, low inflation and low interest rate" period has shifted into the current "high interest rate, high inflation but low growth" period, asset price adjustments are still ongoing. Before the SVB event, what the Fed was actually concerned about was the high valuation of asset prices instead of financial stability risks. The Fed also made it clear in late February that valuations in both real estate and the stock markets are still on the high side, so the adjustment is not over. Considering the turmoil in the EU and US banking sectors, lenders will shrink credit, which will weigh on economic adjustments and have a greater impact on some specific industries. For example, nearly 70 percent of commercial loans given to US real estate developers are from small and medium-sized banks. If smaller banks are seen in contraction, the price of US commercial real estate will be further adjusted.

Fourth, there has been a negative feedback effect of the decline in financial assets. Financial asset prices tend to rise sharply when monetary easing occurs, but the negative impact during declines is greater than the driving force amid rises. Powell now faces a dilemma, which is to stabilize prices, growth and the financial sector all at the same time. It should be noted that prices of financial assets are always overshooting and the impact should be kept under close scrutiny. Moreover, deducing from a financial risk to a financial crisis is nonlinear, and using linear methods to predict nonlinear crises is often prone to misjudgment.

Finally, the recent banking troubles represent the first such issue encountered in the information age. The Asian Financial Crisis in 1997-98 was the first crisis in the era of globalization. This may be the first financial setback to occur in the modern information age. A major point Credit Suisse mentioned in giving reasons for its black swan event is that information is now spreading so fast that bank deposit holders can withdraw their money almost instantly. Also, with the Swiss government's damaged credibility, there are risks possibly leading to a self-reinforcing and self-fulfilling financial crisis. Financial institutions live on leverage tools. No institution can withstand a run.

Homework after incidents

At the macroeconomic level, China must continue to hold its ground and keep the economy running at a steady pace. In the history of Fed tightening, there have often been recessions and financial crises. Though there are various estimates of the probability of a crisis, planning accordingly is far more important than just making forecasts, and it is necessary to be fully prepared for bad scenarios.

Therefore, we should prepare in advance for the deterioration of the various external economic environments and the financial environment, and study in advance whether fiscal or monetary policy tools should be used to hedge against risks from external shocks. It is necessary to maintain the flexibility of exchange rate policy and give full play to the role of exchange rates as a "shock absorber" for internal and external shocks.

Government departments should prepare for the impact of financial spillovers from overseas monetary tightening. The spillover impact of Fed tightening on China last year was mainly financial shocks, primarily through financial markets and cross-border capital flows. The impact through this channel still exists this year. The market panic caused by the turmoil in the West's banking sector has subsided somewhat of late. However, its spillover effects, transmitted via financial markets, may still linger among financial institutions.

In addition, the crises over US banks were to a certain extent triggered by self-reinforcement and self-realization in the market during the modern information age, which, therefore, pose more and higher requirements for liquidity management and crisis handling among financial institutions and regulators. We should reevaluate the current mechanism for dealing with financial risks and crises and improve responsiveness speed and efficacy on the policy side.

Finally, at the microeconomic level, market entities should further strengthen foreign-related financial risk management. The recent turmoil should be deemed a vital test of China's overall planning effectiveness — which integrates financial opening with fending off financial risks — over the past decade or so. Fending off foreign-related financial risks should not be shouldered by the government alone but by market entities as well. To this end, foreign trade enterprises should strengthen management of import and export receipts and payments using foreign exchange. Financial institutions, especially large banks and sovereign wealth managers, should check counterparty risks and avoid overreliance on external ratings. All institutions and enterprises should be of clear mind about the risks and limitations of foreign financial assets and liabilities, and actively safeguard the security of foreign financial investments and financing.

The writer is global chief economist of BOC International, Bank of China.

The views don't necessarily reflect those of China Daily.