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The US banking crisis continues to deepen despite Federal Reserve chairman Jerome Powell claiming that the turmoil surrounding regional banks had been brought under control. According to many banking experts, almost half of US banks are nearly insolvent as they burned their capital buffers. Also, the current crisis has yet to bring to the fore the non-banking financial institutions (NBFIs) or what is also known as shadow banking. The actual extent or the seriousness of the banking crisis will be understood when their condition becomes clearer.
According to a Hoover Institute report prepared by Professor Amit Seru, a banking expert at Stanford University, around 2315 banks across the US are currently sitting on assets less than their liabilities. The market value of the loan portfolios of these banks is reportedly US$2 trillion less than the stated book value.
The recent announcement by regional US bank PacWest that it was exploring a potential sale after its stock crashed 58% has sparked concerns that it could become the next US lender to implode following the collapse of three regional banks since March. The plunge in PacWest shares is particularly significant as the Financial Times wrote that more than three-quarters of its lending is in real estate, a sector which is being hard hit by the interest rate hike.
It is commonly suggested that banking crises occur when the financial sector fails to function effectively, leading to the collapse of one or more financial institutions. It is also suggested that the most common cause of banking crises is excessive risk-taking by financial institutions. The other major reason is the presence of many non-performing loans. Both or any of them can adversely affect the financial stability of banks, which can cause a ripple effect across the economy, leading to a decline in economic activity and an increase in unemployment. But the real story is much more complex than presented here.
Meanwhile, gold prices have been hovering near record highs amid renewed investor concerns of a deepening financial crisis and the possibility of a recession this year in the US. Demand for gold traditionally rises in market uncertainty to hedge risks and as a store of value.
The rise in the price of gold in recent times, the ultimate store of value, is also seen as a reflection of the declining dominance of the US dollar in the global economy. However, ultimately as a fiat currency, the value of the US dollar is not backed by a store of value; its value rests on confidence in the US government.
The US Federal Reserve (the Fed) has created a seemingly unending money supply by accelerating quantitative easing (QE) since 2007-09 to provide monetary support to the stock market and financial system. The Fed could do so because of the role of the US dollar in the global economy; no other government could do so.
The Fed loaded up on public and private debt, driving interest rates to zero. The Fed's balance sheet reached US$9 trillion, more than a third of US GDP. Fiscal support to stimulate aggregate demand to prevent rising unemployment further added to public debt levels. By the end of 2022, the ratio of public debt to GDP in the US reached 129%, the same level as in WW II.
Recent bank failures leading to continuing banking crises over the last three months have raised the prospect of another financial crisis and renewed calls for a stricter regulatory framework for banks. But, more importantly, why the banking crisis has become a regular feature of the contemporary economic landscape of the most advanced economies worldwide also needs to be critically investigated. Such an inquiry will help to understand whether stricter bank regulations will be the answer to the problems created by financial institutions themselves.
The current financial crisis has some standard features with those of the 2007-09 global financial crisis (GFC) but is also different in the sense that the scale and dimension of the current crisis so far are not as big but still have some way to go. The GFC was a systemic crisis of financialization which is usually used to describe the development of financial capitalism from the 1980s to the present. Clearly, financial capitalism emerged with the onset of the neoliberal market economy or, more precisely, neoliberal capitalism during the Reagan-Thatcher era. Both are closely intertwined.
According to a Woking Paper (WP 525) published by the LevyEconomics Institute of Bard College, "Financialization is a process whereby financial markets, financial institutes and financial elites gain greater influence over economic policy and economic outcomes. Financialization transforms the functioning of economic systems both at the macro and micro levels".
The WP further elaborates on the impacts of financialization on the economy; "Its principal impacts are to (1) elevate the significance of the financial sector relative to the real sector, (2) transfer income from the real sector to the financial sector, and (3) increase income inequality and contributes to wage stagnation. Additionally, there are reasons to believe that financialization puts the economy at risk of debt inflation and prolonged recession".
In summary, financialization refers to the increase in size and importance of a country's financial sector relative to the real economy. Since the onset of financialization in the 1980s, the overall value of global financial assets has sky-rocketed from US$56 trillion in 1990 to US$219 trillion twenty years later. In the US, the size of the financial sector as a percentage of GDP grew from 2.8 per cent in 1950 to 21 per cent in 2019. Financial services now constitute one of the most critical sources of exports from the US. It is also to be noted that financialization has also occurred in many emerging market economies.
In fact, it can be argued that the GFC of 2007-09 was a systemic crisis of financialized capitalism which had expanded quite aggressively in the previous two decades. What we are witnessing now is the crisis of financialized capitalism that has gone past its peak. So much so large banks and non-bank financial intermediaries are now simply incapable of operating without extensive support from central banks such as the Fed, ECB, BoJ and BoE. Through their massive interventions, they brought interest rates to extremely low levels, in some cases below zero in the post-GFC period. The growth of the NBFI sector accelerated in the post-GFC period.
The real beneficiary of the low-interest rate regime were non-bank financial intermediaries (NBFIs) or the shadow banking system, which include pension funds, insurers and hedge funds, mortgage lenders and private equity funds. They are engaged in activities like traditional banks except for taking deposits such as those in checking or savings account. This limitation enables them not to be subject to the same regulatory oversight from federal and state financial regulators. However, there are high levels of interconnectedness among NBFIs and with traditional banks and, as such, become a vital channel for the amplification of financial stress.
The global shadow banking system grew rapidly in the years leading up to the GFC of 2007-09. As a result, some of the entities within the system directly contributed to the spread of the crisis. Yet, the growth of the shadow banking system or the NBFI sector accelerated after the GFC, accounting for nearly half of the global financial assets. In its latest Global Financial Stability Report, the IMF pointed out that NBFI stress tends to emerge alongside elevated leverage, such as borrowing money to finance their investments or boosting returns or using financial instruments like derivatives.
Fast rising inflation in decades threatens the foundation of financialized capitalism, preventing central banks such as the Fed or the ECB from injecting central bank liquidity to maintain the overall financial system stability. By the second quarter of 2023, the Fed funds rate rose to 5.25 per cent, the highest since September 2007, after sitting at zero per cent for more than a year during the Coronavirus pandemic. Moreover, the rate has steadily climbed since March 2022 as the Fed aims to fight inflation.
Suppose interest rates stay at the current high levels to bring inflation down. In that case, the possible losses on holding bonds and other financial assets may amount to hundreds of billions of dollars, threatening the financial system's health. In addition, there is a growing concern that both NBFIs and commercial banks face huge holes in their balance sheets. If that is the case, the current crisis could prove to be equally severe as that of the GFC of 2007-09.
However, US inflation appears to be showing signs of moderating in recent times. According to a report published by the Bureau of Labour Statistics (BLS) on May 10, the consumer price index (CPI) rose by 4.9 per cent in April from a year earlier, the lowest since April 2021. At the same time, inflation eased in April but remains high. Since 2012, the Fed has targeted a 2 per cent inflation rate, and the April inflation rate is also higher than the long-term average, which is estimated at 3.28 per cent. Therefore, the Fed is likely to continue to adjust monetary policy if inflation is not within the target range of 2 per cent, which means despite the downward trend, the Fed is expected to continue to raise interest rates as it tries to tamp down inflation. That is not good news for the health of the financial system.