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The root cause of the latest banking crisis was central bankers, not banks, say Andrew Hunt and Ben Ashby.
In its recent report into the failure of Silicon Valley Bank, the US Federal Reserve was quick to identify the bank’s management as the main cause of the firm’s woes. But the Fed is wrong. The problems lie with central bankers themselves.
While SVB might be an outlier in terms of risk management, the recent spate of bank failures in the US is the worst and quickest since the 2008 financial crisis.
When combined with other problems in the financial system, including the UK’s LDI pension debacle last year and the demise of Credit Suisse, it should be obvious that these are not isolated incidents. Rather, they are the systemic fallout from a period of policy excess from central banks, many of which still apparently fail to appreciate the consequences of their actions.
The truth is that quantitative easing, coupled with zero-interest-rate policy, was always reckless. While the authorities might be forgiven for being a little overzealous in their initial response to the pandemic, the truth is that they remained far too generous for far too long.
The result was that they fuelled damaging inflation in the real economy, swelled asset bubbles and encouraged risky behaviour. The pandemic was first and foremost a shock to the real economy, and monetary policy is notoriously poor at addressing such events.
Instead, quantitative easing created both too much and the wrong sort of liquidity: the forced inflows of freshly printed, fickle deposits obliged financial institutions to take on too much risk at the wrong prices. This led directly to today’s instability in the banking sector, where those chickens are coming home to roost. We are not in the clear yet, either. In fact, it is likely that these are still early days of the fallout as the system slowly returns to normality.
mainstream economics is not close to being a science
The basic problem is that central banks and regulatory agencies are staffed by too many academic economists and policy-makers, many of whom lack real-world experience. If that was not bad enough, we are now asking the very same people who have failed at their primary task of ensuring financial stability to start supervising new frontiers such as the greening of the economy and central bank digital currencies (CBDCs).
Contrary to what the academics would have you believe, mainstream economics is not close to being a science. It has long been claimed that economics suffers from ‘physics envy’. So many of the consensus ‘models’ may be increasingly impressive mathematical constructs, but they often do not work.
This is due to the fact they are often dependent on unrealistic assumptions and fail to account for the complexities of the real world in areas like human behaviour, psychology and international financial flows. The reality is the global economy is a complex adaptive system that cannot be reduced to the models and theories that economists like to use.
Even those central bankers who claim experience in the markets, such as the European Central Bank’s Mario Draghi or the Bank of England’s Mark Carney, often come from the research departments of investment banks.
As market practitioners know, a bank’s economists do not play any part in the risk-taking activities of a bank. They write papers and give presentations for what might be described as infotainment purposes, and usually with an optimistic ‘spin’ attached. The point is to get clients to deal.
Only in the public sector would these individuals come to hold such enormous sway over real world activities. Whatever the personal intuition and good intentions of Fed chair Jerome Powell, who does have genuine experience, he remains highly dependent on the Fed’s clique of research staff.
Central banks and regulators need people with first-hand experience of the markets who understand how the system may evolve when faced with new challenges, opportunities and even new regulations. Instead of listening to the far-removed economics department, they would be better advised to listen to banks’ treasurers and senior risk managers.
These are the people who actually manage financial institutions’ balance sheets.
[central banks] would be better advised to listen to banks’ treasurers and senior risk managers
Central bankers must recognise the limitations of traditional economics and embrace a more holistic approach that considers the complexity of the real economy. They need to be willing to admit when they do not know something and be comfortable with uncertainty.
Help may be one the way in the form of new technologies such as artificial intelligence, but only if they are properly embraced.
With regulators, there needs to be a recognition that less is often more. Overly complicated regulations, such as those that followed the global financial crisis, have been shown to fail to keep up with changes and innovations in the real world. Moreover, they encourage new – often less transparent – forms of behaviour, as Credit Suisse demonstrated.
Excessive regulation of on-balance sheet behaviour simply spurs growth in off-balance sheet activities and less regulated entities. Additionally, there seems to be no recognition that more regulation can increase systemic risk because it reduces diversity and even transparency in the system.
If every institution is doing the same thing at the same time, then they are all vulnerable to the same risks and can fall like a line of dominos. More diversity in the system is crucial to absorbing shocks.
So the continuing run of bank failures can be attributed to too many central bankers being academic economists and policy-makers, rather than people with real-world experience. The reckless use of immense quantitative easing coupled with zero-interest-rate policies did not just encourage financial institutions to participate in a misallocation of capital and excessive risk-taking, it practically compelled these behaviours.
Only by having a different kind of central banker can we avoid future economic disasters and create a financial system that benefits society.
Sadly, to paraphrase Max Planck, the only thing that central banking has in common with physics is that this change is only likely to happen one – financial – funeral at a time.
Andrew Hunt is chief executive of analysis service Hunt Economics and Ben Ashby is head of investments for investment management company Henderson Rowe.
