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IMF warns of risks to global financial stability

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International Monetary Fund (IMF) managing director Kristalina Georgieva while speaking at the China Development Forum in Beijing on Saturday (March 25)  warned that the global economy faces risks to its financial stability  because of fallouts from the recent banking crises and the formation of rival economic blocs triggered by the Ukraine conflict.

Georgieva also said that 2023 would be "challenging" and the world economy was likely to see  growth slowing to below 3 per cent 'as scarring from the pandemic, the war in Ukraine and monetary tightening on economic activity". She also mentioned the recent crisis in the banking  sector in the US and Europe which exposed vulnerabilities in the global financial system.

She further said at the conference, "At a time of high debt levels, the rapid transition from prolonged period of low interest rates to much higher rates - necessary to fight inflation - inevitably generates stresses and vulnerabilities, as evidenced by recent developments in the banking sector in some advanced economies".

She praised policy makers swift responses to the banking crisis and  collaboration by major central banks to support the global banking system by boosting the flow of US dollars around the world. She said that they "have acted decisively in response to financial stability risks". She also noted that "These actions have eased market stress to some extent, but uncertainty is high which underscores the need for vigilance".

Georgieva also said that the IMF was continuing to watch the situation, and assess potential implications for the global economic outlook. Global investors  as well are on high alert about the health of the banking sector following recent collapse of Silicon Valley Bank (SVB) along with two other US regional banks and the collapse of Credit Suisse in Europe.

Now the immediate focus in the US is the fate of First Republic Bank which is in danger of going the way SVB other two banks have gone despite  US$30 billion pumped into the bank by 11 major US banks headed by JP Morgan. First Republic's shares have plunged 90 per cent this month (March). Over the last week Bloomberg News reported that about US$600 billion worth of stock market value had evaporated from the 70 biggest US and European banks.

Last week, in a US Senate Banking Committee hearing  evidence emerged that the regulators knew about the extent of the run on SVB which led to its collapse and also knew about its problems but did nothing. Federal Deposit Insurance Corporation (FDIC) chair Martin Gruenberg said that the FIDC estimated the cost of covering SVB's deposit at US$20 billion and that of Signature Bank at US$2.5 billion. He further added that without government intervention there was significant risk of contagion and serious stress elsewhere.

Yet, support delivered by authorities in the US and Europe to stabilise the banking sector has raised serious questions over moral hazard of effectively bailing out banks. The Wall Street Journal also raised concerns about the financial guarantee provided by the US government to banks. It argues that by doing so the market was not allowed to carry out necessary corrections with implications for government finance.

In Europe the focus of attention has now turned onto Deutsche Bank and there is growing speculation whether it might also go the Credit Suisse way. It is the 8th largest bank in Europe, also it is an EU bank.  Its shares dropped by 15 per cent already. German Chancellor Olaf Schotz quickly intervened in response to the share market fall and tried to reassure the market and said "There is no reason whatsoever to be concerned". He also emphasised it is a profitable bank.

But the euro area still does not have a common deposit insurance mechanism which is widely considered as the key defence against any banking crisis that may emerge in future. A stalemate among Euro area's 20 member countries over how to share risk left the area without such an important regulatory institution.

However, Deutsche Bank like Credit Suisse has a  long history of undertaking fraudulent banking activity and featured very prominently in the 2011 US Senate Report on the 2008  financial crash because of its heavy involvement in the sub-prime fraud.

Furthermore, Credit Suisse had problems of its own over and above fraudulent banking practices including money laundering such as  missteps over risk management going back over years and last year recorded a heavy loss. In a law suit filed against Credit Suisse in the US recently alleged that the bank made "materially false and misleading statements" in its 2021 annual report. Credit Suisse so far declined to comment on the lawsuit. To further compound the bank's problem, a two year investigation by the US Senate Finance Committee very recently found that Credit Suisse had violated the terms of a  plea deal and had continued to conceal the bank accounts of wealthy Americans.

The deal arranged by the Swiss National Bank forcing Credit Suisse to merge with UBS also involved an unprecedented action. Instead of shareholders losing all their equity and bond holders to  recover some of their losses from the sale of remaining assets, as typically occur when a bank or corporation collapses; but in the takeover of Credit Suisse these rules were overturned. Now the holders of US$17 billion worth of Credit Suisse junk bonds (AT1) would get nothing while equity holder of Credit Suisse will receive a partial bailout of US$3.3 billion.

It is to be noted that Additional Tier 1 (AT1) bonds were introduced after the 2008 global financial crisis as an additional layer of protection. AT1 bonds are issued by banks to investors designed to absorb losses. Now the way they have been wiped out has become a point of controversy.

The Swiss government, the regulatory authority (Swiss Financial Market Supervisory Authority) FINMA and the Swiss National Bank  (Swiss central bank) have been criticised by the President of ECB and the Governor of BoE for the way in which they overturned agreed procedures in organising the rescue of Credit Suisse.

It has been suggested by a columnist of the Financial Times that the reason for such reversal of the rule was to ensure that powerful Saudi investors (the Saudi National Bank which held 10 per cent of equity) are compensated however modest that might be so as not to offend them. But the credit Suisse collapse has now cost the job of Ammar Al Khudairy, the chairman of Saudi National Bank. He has resigned from his position.

The world of banking is extremely complicated and susceptible to a range risks such as credit risk, liquidity risk and interest rate risk. It is always hard to identify where the new challenges or threats might be coming from. The situation become even more complicated and dangerous when banks resort to corrupt  practices.

The unfolding of banking crisis in the US and Europe has had a common factor that affected all the collapsing banks both in the US and Europe. It is the rising interest rates. Central banks around the world have been raising interest rates to dampen down rising inflation. The financial crisis of 2008 started a course of events that led major central banks to slash interest rates almost to zero - in some cases even below zero. So, after years of very low interest rates, the current interest rate hikes to battle inflation have created "stresses and vulnerability" as IMF head Georgieva said recently in Beijing.

When interest rates rise, bond prices fall. When there is run on  banks, they are forced to sell these bonds  in the secondary market for bonds at a lower price reflecting the declining value to raise cash to enable the withdrawals to be made. This leads to reduced capital base making banks unable to pay up depositors' fund. 

In summary,  banks will have a problem if they cannot keep their asset valuation higher than their deposit liabilities. Rising interest rates  force banks like SVB and Signature and  the like  to sell US government bonds at a discount causing banks' asset structure to weaken.  In fact, the problems of liquidity and solvency for banks have already deepened the crisis causing turbulence in the US bond market. 

Now it is widely feared that these banking stresses are leading to widespread credit crunch which will slowdown economic activity  around the world.  An editorial of the Financial Times last weekend also expressed the view  that even if there is no further crashing of banks "higher interest rates have already slashed lending to the real economy, and banks are likely to raise their lending standards even further in response to recent events".  Obviously, such actions will feed through the real economy causing lower growth.

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