Global financial system tested by stubbornly high inflation, rising interest rates

Global financial system is clearly tested by stubbornly high inflation in many developed countries and rising interest rates around the world.
Banking oversight was significantly strengthened after the global financial crisis, in part by requirements for banks to hold more capital and liquid assets and be stress tested to help ensure resilience to adverse shocks.
Yet, the global financial system is showing considerable strains as rising interest rates shake trust in some institutions, according to International Monetary Fund (IMF).
The failures of Silicon Valley Bank and Signature Bank in the US — caused by the fleeing of uninsured depositors out of the realisation that high interest rates have led to large losses in these banks’ securities portfolios—and the government supported acquisition of Switzerland’s Credit Suisse by rival UBS have rocked market confidence and triggered significant emergency responses by authorities.
IMF’s latest Global Financial Stability Report shows that risks to bank and non-bank financial intermediaries have increased as interest rates have been rapidly raised to contain inflation.
“Historically, such forceful rate increases by central banks are often followed by stresses that expose fault lines in the financial system,” noted Tobias Adrian, financial counsellor and director of the monetary and capital markets department of the International Monetary Fund.
In its role of assessing global financial stability, the IMF has flagged gaps in the supervision, regulation, and resolution of financial institutions.
Previous Global Financial Stability Reports warned of strains in bank and non-bank financial intermediaries in the face of higher interest rates.
While the banking turmoil has raised financial stability risks, its roots are fundamentally different from those of the global financial crisis. Before 2008, most banks were woefully undercapitalised by today’s standards, held far fewer liquid assets, and had much more exposure to credit risk.
In addition, there was excessive maturity and credit risk transformation of the broader financial system, high degrees of complexity of financial instruments, and risky assets predominantly funded by short-term loans.
Troubles that began at some banks quickly spread to non-bank financial firms and other entities through their interconnections.
“The recent turmoil is different,” Adrian says. The banking system has much more capital and funding to weather adverse shocks, off balance sheet entities have been unwound, and credit risks have been curbed by more stringent post-crisis regulations. Instead, it was a meeting between the steep and rapid rise in interest rates and fast-growing financial institutions that were unprepared for the rise.
At the same time, we also learned that troubles at smaller institutions can shake broader financial market confidence, particularly as persistently high inflation continues to cause losses on banks’ assets.
In this sense, the current turmoil is more akin to the 1980s savings and loan crisis and the events leading up to the 1984 failure of Continental Illinois National Bank and Trust Company, which was then the largest in US history. These institutions were less capitalised and had unstable deposits.
Faced with heightened risks to financial stability, policymakers must act resolutely to maintain trust. Gaps in surveillance, supervision, and regulation should be addressed at once.