Broken banks (II)

The years of bonanza, of easy money, with interest rates close to 0%, and even negative, seem to have disappeared for a long period of time.

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The global financial crisis of 2008 left millions of victims, primarily in Europe and the USA.

The original cause of the financial collapse was due to the difficulties in determining the true value of asset portfolios of varying quality, known as subprime, which led interbank markets to suspend the credit that banks granted to each other. It was a clear example of distrust - the suspension -

Restoring and keeping trust, is essential for the banking business to function and serve as an effective agent in the distribution of savings towards credit and investment, and thus the creation of wealth, something that no other institution - public or private - is capable of achieving.

With the suspension, financial flows in interbank markets were interrupted, causing the collapse of entities unable to solve their liquidity and solvency problems.

Faced with this situation, central banks and government authorities came to the aid of the banking industry - once again, at the expense of taxpayers - with capital injections, abundant credit facilities, and the liquidation of entities through mergers and forced bankruptcies, to the misfortunes of shareholders, depositors, and employees.

In Spain, the storm of 2008 took six years to regain the vital signs of a growing economy with a more solvent financial sector.

An estimate of the cost incurred during the period 2009-2015 to the Spanish taxpayer, mortgage debtors, financial institutions, companies, and workers in terms of Gross Domestic Product (GDP) exceeds 368 billion euros.

Calming down the markets

If there is something that keeps the central banker up at night, it is precisely maintaining the calm of the financial markets. Those who work in banking also feel this pressure, but prefer to keep silent, as it could be the case that an excess of words ends up wiping out their deposits.

The minister of economy - and by extension the president or prime minister in office - attempt to maintain market calm when they become nervous by relying on stale messages of vacuous optimism.

They either tend to disdain or deny the reality of an economic recession, or envision green shoots where the common person sees a barren wasteland, while inflation and rising food prices seem to matter little or not at all.

Maintaining market calm, in banking practice, means issuing messages that are restrained and frequently cryptic and unintelligible to the average person, in an effort to "appease" reality when interest rates are expected to rise, or inflation spirals out of control, or confidence in financial institutions is threatened, usually due to their own poor business practices.

Liquidity before insolvency

The banking industry, if it knows anything - and is recognized for it - is managing the implicit risks that accompany the prudent use of money. Empirically, regulators, supervisors, and bankers know that an entity collapses more often due to lack of liquidity than insolvency, nevertheless, the former tends to provoke the latter...a matter of time, short.

?The recent banking crisis that has arisen with virulence among American regional banks teaches us some valuable lessons.

The first lesson that can be drawn from the American crisis refers to the managemente of the liquidity risk (the ability to cope with deposit withdrawals).

Empirically, regulators, supervisors, and bankers know that an entity collapses more often due to lack of liquidity than insolvency, nevertheless, the former tends to provoke the latter...a matter of time, short.

The second lesson refers to interest rate risk (assets with rates below the market imply a loss in case of needing to sell to meet liquidity needs, for example). A loss that leads to the reduction of the entity's own resources and, eventually, can cause insolvency.

The third lesson illustrates insolvency (the inability to meet debts) as a cascading effect of the occurrence of the previous two risks. Finally, and no less important, as recognized - and they accept responsibility for - by American regulatory and supervisory authorities, the weakness of regulatory requirements and laxity in the implementation of monitoring systems.

The bonanza years

The damage caused by the insanely low interest rates to those involved - households, investors, credit institutions, and even our taxpayer Juan Espa?ol - has not yet been accurately measured. Juan has seen his money used to bail out a good number of financial institutions, or simply how the losses generated by these institutions reduced tax revenue, 11 years later (2019, the most recent data), the losses appear in bank balances as tax assets worth over 67 billion euros. This would mean that the banking industry has caused losses of credit and investment assets of around 300 billion euros.

In summary, the billions of losses have impoverished society as a whole, and lost revenue for the Public Treasury - that is, the hardworking taxpayer - due to the missed tax income.

The years of easy money with interest rates close to 0%, and even negative, seem to have disappeared for a long period of time. Out of the 15 years between 2008 and May 2023, interest rates have remained below 1% for just over 9 years.

Looking back at the behavior of the 12-month Euribor rate - used as a reference to set prices for mortgages, among others - the maximum rate was reached in July 2008 at 5.393%. After the financial crisis, the Euribor remained below 1% for 3 years (August 2012 - January 2016) and at negative rates for 6 years (February 2016 - March 2022), with a maximum of -0.505% in January 2021.

Comparing inflation and Euribor in the reference periods, while inflation recorded an increase of 4.9% in July 2008 - the period of maximum Euribor - approximately 50 basis points below the Euribor. In April 2023, with inflation at 4.1%, or 34 basis points higher than the Euribor, it points to the need for further interest rate hikes, or inflation will continue to erode savings and spiral out of control, ultimately hurting the average citizen's cost of living.

The years of bonanza, of easy money, with interest rates close to 0%, and even negative, seem to have disappeared for a long period of time.

Regulators and supervisors

The European Central Bank (ECB) has a laborious task ahead of it to rein in inflation and bring it to its target rate of 2%, primarily through further interest rate increases, as the main axis of its monetary policy to be developed in the near future.

A monetary policy, maintained by both the American Federal Reserve and the ECB, of low interest rates and a spectacular increase in money circulation and purchase of public and private debt by central banks –the famous quantitative easing– that seems to anticipate more of the same…: recession, inflation, unemployment, bank crises, in a recurrent "carousel" to which interruptions in supply chains, wars, pandemics, shortages and high food prices add some of the threats that condition the formulation of policies in favour of society as a whole.

At the same time, with regards to financial entities in the euro zone, regulatory and supervisory authorities have a huge task ahead of them to redirect the banking business towards more reliable, efficient and robust paths, avoiding the harmful effects of contamination from institutions from both European and foreign jurisdictions.

Original published in Spanish in La Voz de Córdoba, May 31, 2023