Breakage

We know why earthquakes happen – even as we do not have the science to predict them.

Quakes happen along fault lines, where tectonic plates push against each other. Pressure builds up until, at the weakest point, one part breaks. One plate yields to the other in a crushing event. The effect of the break is jolting.

By analogy, the international financial system is now being subjected to increasing pressure. The source of that building pressure is a long cycle of rising interest rates. Central banks everywhere have been in a sort of arms race, each raising rates as a means to curb inflation as well as defend exchange rates. It has become a contest of who can grin and bear the economic pain the longest.

Sky could not possibly be the limit here. At some point, something gives. A financial shock hits the system. Breakage happens.

Often, the breakage happens in the banking system. It is the barometer of an economy’s health. It is also most vulnerable to the pressures created by rising interest rates.

As interest rates rise, some borrowers may have trouble refinancing their debt. Providing for working capital becomes too expensive. This reflects in a rise in the ratio of nonperforming loans.

It could also happen that the banks themselves have trouble maintaining their own capital adequacy. Banks borrow from other banks regularly to keep themselves liquid. That regular exercise becomes too costly when interbank rates rise. This could be disruptive.

I served on the board of the Development Bank of the Philippines when the 2008 financial crisis happened. I recall that, months before, we ordered closer monitoring of the credit card business. Consumers, especially American consumers, were borrowing unsustainably on their credit cards. Rising defaults could spell trouble for the international banking system and lead to a breakage.

As it turned out, the break happened in the mortgage business. Investment institutions were lending heavily to subprime borrowers. To compound things, banks were repackaging these loans into all sorts of derivatives to raise more financing to lend some more.

We had an interesting acronym for these borrowers: NINJA. That stood for no income, no jobs and no assets. A bit too much of the mortgage financing went to this category of borrowers.

When a certain level of defaults on mortgage payments was reached, the business simply crumbled. When Lehman Brothers abruptly shut down, the investment institutions seemed to crumble like a house of cards. Debt paper based on financial derivatives that were, in turn, based on subprime lending became worthless overnight. The international banking system seemed ready for a meltdown, saved eventually by the decision of central banks to infuse money into the system by buying up bonds from the banks.

We see shades of another banking crisis looming.

Last Thursday, panic swept through the New York Stock Exchange after one bank, lending primarily to the tech industry, informed its investors it had to sell $1.75 billion in shares at a loss. This had to be done to cover rapidly declining customer deposits. The Dow fell 543 points that day, a loss of 1.7 percent. The Nasdaq Composite, reflecting the tech industry, fell even more dramatically by 2.1 percent.

The shares of the major banks were losing the most. JP Morgan Chase dropped by 5.4 percent, Bank of America by 6.2 percent, Wells Fargo by 6.2 percent and Citigroup by 4.1 percent.

Americans are famously bad at savings. A decline in customer deposits means that, aggravated by inflation, they were saving even less.

With less deposits, the banks have to borrow to finance their own operations. With the rising interest rate regime, the cost of money becomes a challenge.

Too, US banks are sitting on a large stash of bonds and Treasuries acquired when interest rates were close to zero. In the current high interest rate regime, the value of this stash is worth very much less. The large banks are, therefore, sitting on paper losses that will have to be accounted for eventually.

The fact that a bank lending largely to the tech industry comes first to sell shares at a loss is significant. Many tech start-ups are heavily leveraged and not yet profitable. In an environment where the peril of recession looms large, that is not a healthy thing.

Should the central banks continue raising interest rates, financial instability could quickly ensue as businesses begin to fail. The cost of money for operating capital matters. In an inflationary environment, consumers will effectively have less money to spend.

Earlier this week, the Dow fell sharply after indications the US Fed would continue to raise rates aggressively. Doing so will definitely help slow inflation by dampening the demand side. But it could also bring the US economy closer to another breaking point.

Our own BSP has likewise signaled another interest rate increase is coming. The hike will either be a quarter or half a percent. This is the only suspense.

Raising interest rates is really demand destruction. It is a brutal tactic to cool the economy by making it more difficult for businesses to thrive.

Central bankers are mission-driven. Their mission is to manage inflation. They can have a propensity to accomplish that mission even if it means killing the economy.

There are indications that the pursuit of higher interest rates to curb inflation might have reached the limits of their utility. Beyond that, the cure becomes worse than the disease.