Financial Stress and Trust in the Financial System

Over the past year, the Federal Reserve has swiftly tightened the monetary policy by increasing the federal funds rate and introducing quantitative tightening (reversing the quantitative easing in the past decade). All the actions have taken place to lower inflation, ease the pressure on falling real wages, and prevent a wage–price spiral. Raising the rates brought uncertainty and risks to the financial markets as the pressure is mounting on the economy and the financial system. One must be aware of the velocity of raising rates, which is the fastest in the past thirty years. By now, The Federal Reserve has raised the rates by 500 bps in fifteen months which still hasn’t fully impacted the economy.

Federal Reserve has quickly tightened the monetary conditions in 2022 and 2023 to curb inflation and bring it back to the 2% inflation target.  According to the Kansas City Fed’s Financial Stress Index (KCFSI), levels of financial stress seen in the past three months rose to levels similar to the crises in 2011 and 2000 – 2003. In March 2023 when the Silicon Valley Bank and Credit Suisse went under KCFSI was at 1.15. Since March, it fell to the current level of 0.91. During the Covid Crisis KCFSI recorded levels of 2.66 and during Great Financial Crisis in 2008 – 2009, it reached a peak of 5.76. Historically, spikes in KCFSI lead to higher unemployment and lower inflation as banks tighten their lending conditions and adopt conservative risk policies in post crises environments. Thus, it should be expected that investments fall due to the unavailability of credit and postponing capital projects as companies wait for brighter economic times and lower interest rates.

Fortunately, after the 2008 financial crisis, supervision of the banking sector has increased dramatically, especially in Europe to prevent renewed „Lehman moments“ and to protect the system that primarily lies on trust. Occasional loss of trust in the financial system leads to more financial stress as the bank runs to put pressure on the financial system. As a result of protecting the fiduciary role of the financial system, Federal Reserve decided to backstop and relieve financial stress to prevent further fallout in the financial system. The idea of preventing further fallout involves major state intervention and the reduction of market forces in the short term, however, it protects the stability of the system, and the overall trust and it might seem like a much better opportunity than leaving the banks on their own. As deposits are the major source of funds that banks are using to finance their assets, a backstop seems to be the right thing to do to prevent major failures and the collapse of the system. Making every effort to stop further collapse implies that the financial system is too big to fail and the central banks in times of volatility must be ready to protect it at all costs as there is no other acceptable option. If the central bank lets just one small bank completely fail, it bears consequences for the whole financial system. As a result, bigger banks are incentivized to cooperate in times of financial stress to contain the volatility and safeguard their own position on the market. As I wrote in one of my previous blogs, the banking sector is bound to consolidation as the financial stress impacts smaller banks first as they are subject to milder regulation. Unfortunately, the described forces centralize the industry, and higher levels of regulation are needed to prevent risky operations which might imperil the system as a whole.

As long as the restrictive monetary policy is in use, there is no opportunity for smaller banks to shine as the credit volumes are shrinking and the risk of holding stocks of smaller banks is much higher. The payoff of holding the stock until expansionary monetary policy comes back in place is very limited as investors can lose a huge share of the investment regardless of the condition of the bank, but just because of the uncertainty across the sector. Also, an investor might close the position before the new expansionary cycle to recover at least some of its investment. All mentioned above describes a short-term and even longer-term tendency of the sector to become even more regulated, thus reducing the chance of smaller banks becoming bigger ones as a result of protecting the whole system in times of financial stress. Reducing the chance of disrupting the whole system in times of financial stress leads the industry as the risks in times of financial stress are much more important than growth during expansionary times. In terms of the KCFSI, I would argue for lower levels in the future as the sector is becoming more and more regulated and the oligopoly in the banking sector is the future as it reduces financial stress. The only alternative to it is further regulation of smaller banks, but on the other hand that reduces their future growth. The whole banking sector is not oriented to growth, but to survive in times of financial stress and more regulation is the way to support the real economy. Lower growth of the banking sector in combination with higher regulation in terms of a modern highly financialized economy might lead to lower market competition, but also lower risk which is the policy that Europe already adopted after the GFC.

Kristijan Božić
Category : Blog

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