The Problem For and Of The Banks

The problems in the banking sector, seen with the collapse of SVB and Signature, in the US, and Credit Suisse in Switzerland, are not over. The last week or so has seen continued selling of the shares of US regional banks, and further collapses, with larger banks, like J.P. Morgan, having to come in to bail them out or take them over. Further consolidation is inevitable and desirable, but also draws the larger banks closer into the vortex, as in 2008. As I set out recently, the problem is not with the profitability of the banks, as higher interest rates lead to wider spreads between their borrowing and lending rates, or, at least, they should. The problem is in relation to their capitalisation, and the value of assets on their books, and, unfortunately, for the banks, those valuations are also a function of interest rates. The next shoe to drop is property prices.

The problem the banks are facing is this. When interest rates rise, they should become more profitable, because the spread between what it costs them to borrow, and what they are able to charge on loans rises. If interest rates are at 3%, a bank might borrow at 2%, and lend at 4%, but if interest rates rise to 5%, it might borrow at 3.75%, and lend at 6.25%. On £1 million, it originally makes £20,000 profit, and now makes £25,000 profit.

The failure of SVB came as a result of customers taking part in an old fashioned bank run, except that, today, with internet, and electronic banking, customers can sit at home, and transfer money out of their accounts in an instant. To avoid a bank run, banks need to be able to show to customers that they don't need to get their money out, because the bank has sufficient capital to cover their withdrawals. That's why the US Federal Reserve stepped in, a few weeks ago, to assure bank customers that they would not lose money, in the case of a bank failure, because the federal deposit guarantee system would cover all of their deposits. That's a big commitment if all bank customers did panic, and start a bank run, on large numbers of banks.

For SVB, to cover withdrawals from customers, it needed to convert some of the assets held on its books. In particular, it needed to sell some of its government bonds, so as to get cash to hand to customers. The trouble is that, as interest rates have risen, the market price of those bonds has fallen. If the bonds could be held to maturity, they can be redeemed at their face value, of, say, $1,000, but the bank needed the money, now, not in two, five or ten years time, when the bonds were due to mature. Selling the bonds now, in the secondary markets, therefore, means that they can only fetch their current market price, which might be only $800. That left a big hole in the banks actual capital, which only becomes apparent when these assets have to be marked to market rather than to book. A similar problem happened in 2008.

Then, it was the value of property assets held on banks' books, at a time of a preceding property bubble, and impending bursting of that bubble. This time around, it has been a massive bond bubble that was inflated in the preceding period, as a result of an even greater amount of QE, and the bursting of that bubble that has provided the initial tinder for the conflagration. Another flicker of it came with the crisis in UK Pension funds, in the Autumn of last year, when the policies of Liz Truss caused UK interest rates to spike, leading to a sudden crash in bond prices, which left some pension funds with a huge drop in the value of their assets, assets which, with the model of the last 30 years, they have relied on to be able to sell to cover liabilities, on the basis of continually inflating asset prices, and capital gains.

Central banks have stepped in to try to prevent that crisis. Last year, at a time when the Bank of England was supposed to be starting QT, it, instead promised a further £65 billion of QE, to provide a breathing space for the pension funds to deal with their funding crisis. The removal of Truss's government, and subsequent rise in UK bond prices, ended the immediate problem. The ECB, fearing a new crisis for its peripheral economies, as with the 2010 Eurozone Debt Crisis, as interest rates rose, sharply, for economies in Greece, Portugal, Italy and Spain, also introduced a new programme of QE targeted at the bonds of those countries, to stop interest rates for them rising, sharply, as against those in Germany and other Northern European countries. In the US, the Federal Reserve has used its open ended backing for the FDIC's guarantee of deposits, along with encouraging the larger banks to bail-out the regional banks, whilst in Switzerland the Swiss National Bank, first tried bailing-out Credit Suisse, and then facilitated its take over by UBS.

But, that is not the whole problem, and so, in the last couple of weeks, we have seen US regional banks continue to come under pressure. The huge US banks are under continual scrutiny from the Federal Reserve. But, they also have larger resources, anyway. But, there is another difference, and that is that these huge national banks, tend to hold different kinds of assets, and liabilities. They are able to borrow more cheaply in money markets, and when they lend money, a greater proportion of it is to large corporations. This where the issue of R* and R** that I wrote about a while ago also comes in.

Why do interest rates rise? Real interest rates rise because the demand for money-capital rises relative to the supply of money-capital. In short, when the economy is expanding more rapidly, the demand from businesses for money-capital to finance the purchase of buildings, equipment, materials and labour-power rises at a faster rate than the increase in realised profits, which supplies the money-capital for that purpose. Those that obtain revenues, be they wages, rent, interest or profit of enterprise, in excess of what they require to finance their current consumption, or who have savings from previous such excess, can be incentivised to lend it by being offered a higher rate of interest for doing so.

Nominal interest rates can also rise as a consequence of inflation, which acts like depreciation. In other words, if I have £1,000 to lend, and the current rate of interest is 3%, but inflation is 10%, at the end of a year, when I get back the £1,000, it will only be actually worth £900, in today's terms. It will have been depreciated by 10%, just as with, say, a machine, whose value falls by 10% over the period of a one year lease. If I lease the machine, I would want to cover that £100 of depreciation, as well as the normal interest of £30, and so would want back £1,130. In the same way, if I lend £1,000, I will want back £1,130, to cover the depreciation of the capital, plus the normal interest. It will look as though the rate of interest was 13%.

So, if businesses, in a more rapidly growing economy, demand more money-capital, interest rates will rise. Consumers might also demand more money to finance the purchase of more expensive consumer durables, such as cars. Banks lending money for such purposes, then, can charge higher rates of interest for these loans, and, as described above, when this happens, the spread between what they pay to borrow, and what they charge to lend, grows wider, and so their profits expand. As their costs for things like bank buildings, equipment, and wages have not changed, these bigger profits mean a larger rate of profit. Indeed, for the bigger banks, the latest earnings season has seen these bigger profits, and rates of profit.

But, the picture is different for the smaller, regional banks. In the US, these regional banks are more akin to the Building Societies that existed in the UK up to the 1990's, and early 2000's, when most of them converted into banks. They rely more on deposits from savers, be they local businesses or households, rather than on financing from operations in the money markets – when they did do that, as with the UK's Northern Rock, prior to 2008, they were hammered when the costs of that short-term borrowing soared, due to the credit crunch – and to retain those savers, or attract more of them, they need to pay higher rates of interest on deposits. Here is where the problem for them resides.

The vast bulk of the loans these banks have made, not just in the US, but also in Britain and the EU, as well as across the globe, has not been to finance capital accumulation by businesses, nor consumption by households. Around 90% of it has been to finance the purchase of property, or other forms of speculation in property. So, whilst these banks could take advantage of wider spreads, as interest rates rise, on loans to businesses, they have an obvious problem charging higher rates to people who have borrowed money to buy a house.

A business seeing the demand for its products and services rise sharply, and the prices it can charge for them, can afford to pay more interest to borrow the necessary money to expand. But, someone who has borrowed money to buy a house, build houses and so on, sees no such ability. Indeed, as interest rates rise, and property prices fall, builders see their own profits drop. In the US, UK, and the EU, as well as in China and other parts of Asia, as interest rates rose, and mortgage rates rose, the demand for mortgages fell sharply, and property prices dropped. Yet, those interest rates are not yet covering the continued high levels of inflation.

In addition, as I have set out before, investment in large scale fixed capital tends to be lumpy. Take something like provision of broadband infrastructure. For a country, it requires a huge investment in fibre optic cables, switching gear and so on, all of which takes place in a relatively short-time. But, you don't build it only to cover current requirements. Once built, the traffic along it can increase every year for many years without any substantial additional investment. The same is true for a business that puts in place its own IT infrastructure, and so on. And, fixed capital can always be used more extensively and intensively, by introducing shift systems, and so on. So, output can increase significantly when demand rises, without any additional fixed capital investment, or borrowing to finance that investment.

What does increase is investment in circulating capital. In other words, businesses may be able to continue using their existing fixed capital, but will need to buy additional materials, and employ additional workers. However, the nature of this circulating capital is that, often, it can simply be financed by an expansion of commercial credit, which always expands in periods of economic expansion, and requires no additional borrowing. But, even where it can't be financed simply from an expansion of commercial credit, often firms can simply finance it out of their own profits, particularly where those profits are themselves expanding in real or nominal terms.

Consequently, a sluggish increase in bank lending to businesses need not reflect any considerable economic weakness. But, overall bank lending figures are even less a guide, given what has been said above, because with a large part of that lending going to finance property purchases and speculation, it simply reflects the fact that rising interest rates are hitting demand for mortgages and property. There is a big difference between that, and lending to finance either business investment, which creates additional employment and aggregate demand, or consumption, which increases consumer demand, and thus leads to business engaging in additional investment to meet it. The majority of house purchases are for existing properties, not new properties.

The appropriate response to the rise in interest rates in relation to property is a fall in property prices. That would mean that demand for mortgages, and for property would then recover, at these lower prices. It also means lower land prices, which, today, account for a disproportionate amount of the cost of building new properties. A fall in land prices would not only reduce the price of new houses, so encouraging additional demand, but it would boost builders rate of profit, stimulating additional supply, and employment, giving a further boost to the economy.

However, its clear why the banks that have built their model around continually inflating asset prices, and which have focussed 90% of their lending on property, do not see things that way. Higher mortgage rates, until such time as property and land prices adjust, means smaller demand for them, and so less profit for the banks. It might also mean that some existing borrowers cannot pay their mortgages and default. But, even without that, a large part of the capital on the banks' balance sheet is in the form of the property held as collateral against the mortgage. Just as with SVB, and rapidly falling bond prices, rapidly falling property prices would again hit their balance sheet requiring them to raise large amounts of capital from share or bond issues.

Banks that have built their model on lending to finance property purchase and speculation find they cannot raise their mortgage rates, because it would choke off demand for mortgages, and would also cause property prices to crash. That is not just the case for residential property, but also for commercial property, the demand for which has already been hit by the fact of people working from home, during lockdowns. If banks can't charge higher levels of interest for these mortgages and property loans, they also can't pay higher rates of interest to the savers they now need to retain and attract. It doesn't require customers to fear a bank run, to bring about a significant fall in deposits. Savers can get a higher rate of return on short-term money market funds than they can get on their savings in a bank.

So, this is the problem faced by the banks. They should be making bigger profits in this environment, on the basis of wider spreads, but for many of them, that isn't happening, because their model is based on lending for property purchase and speculation. Higher lending rates for that will crush demand for loans, and also bring about a crash in property prices, and so impact the balance sheets of the banks, as happened in 2008. To hold down those lending rates, they have to hold down deposit rates, and that makes them uncompetitive with money market rates, leading to a drain of funds, which undermines that capital base, requiring either additional capital raising or bail-outs, sharp drops in their share price, and take over by larger banks, which then get sucked into this maelstrom.

And, that creates problems for central banks. Central banks have created inflation as a result of excessive liquidity creation. To reduce that inflation they need to reduce that excess liquidity, which is what QT should do. However, QT, by preventing firms from raising prices, hits the profits of those firms, as they face higher wages, as a result of the demand for labour exceeding supply. It also means that, instead of buying bonds, central banks have to sell them, increasing the supply of them in the market, causing their prices to fall, and yields to rise.

That would also lead to a fall in share prices, and property prices. Given that the ruling class now owns all of its wealth in the form of these assets (fictitious capital), it is keen not to see that happen, as occurred in 1987, 2000, and 2008, and so its state, via the central bank does all it can to avoid it. Hence QE, and hence the variations of it, in the last year, even at a time when central banks were supposed to be engaging in QT, and were simultaneously raising their interest rates in an attempt to cause recessions, and so slow the pressure on rising wages.

But, the rising inflation means that even with the rise in central banks nominal interest rates, those rates are still significantly negative. So, consumers still have an incentive to spend their incomes rather than save them, especially as rates on deposits are only a fraction of central bank policy rates. Firms have an incentive to continue to expand to satisfy rising demand for their goods and services, especially as they can finance most of it from commercial credit, or else from their rising money profits.

So, the inflation in the system continues, even if it moderates slightly from earlier levels, and central banks then have a problem that if they raise their policy rates further, it simply causes bond prices to fall, and puts further pressure on those banks that cannot raise their mortgage rates accordingly, for fear of choking demand, and causing defaults and a sharp drop in property prices. They face the potential that what it costs them to borrow in capital markets becomes greater than what they can charge on their mortgages, and they can't even keep let alone attract additional deposits from savers, because they can't increase their deposit rates, whilst savers see the ability to get much higher yields on money market funds, and the purchase of short term Treasuries.

Central banks are being posed with the options of either giving an open ended commitment to bail-out these banks as they see their deposit base disappear, or else to engage in even more QE to push up bond prices and try to reduce yields, which would lead to a surge in inflation, once again, or to pivot and reduce their own policy rates, despite having failed to reduce inflation.