Former Reserve Bank of India Governor Raghuram Rajan has expressed concerns over a “big simmering time bomb” in the US economy, which could lead to a domino effect and riskless capitalism for banks.
This comes after three US banks failed since March, raising alarm bells for regulators and depositors.
In a podcast hosted by DBS Bank’s Chief Economist Taimur Baig, Rajan highlighted the US authorities’ response to the bank failures, stating that they are “very worried about a cascade of failures and they’re worried about panic.”
While the short-term problem has been dealt with by the implicit insurance of all deposits, Rajan noted that there is still a longer-term problem with the banking system’s profitability.
Also Read: Why did the Silicon Valley Bank collapse?
The former governor pointed out that there has been a significant increase in uninsured liabilities in the banking sector over the last couple of years, partly due to the enormous quantitative easing that has taken place.
This poses a risk for investors looking for safety and profitability for banks, which is becoming more challenging as rates on safe assets rise.
Banks are trying to pass off half-percent or 1% increases to offset these higher rates, but it may not be enough to sustain their profitability.
Rajan highlighted the risks of losses for lenders who were already reeling under recession fears, as businesses struggle to pay back or service loans due to rapidly increased policy rates. This has resulted in two regional US banks – Silicon Valley Bank and Signature Bank – failing since March. The Federal Reserve’s aggressive rate hikes of 4.5 percentage points since March 2022 were an attempt to tame the galloping inflation rate, but have put banks at risk.
Days after the US saw its second and third-largest banking failures, Credit Suisse, a Swiss banking giant, got into an excruciating financial crisis.
Earlier this month, JPMorgan Chase & Co agreed to buy First Republic Bank after it was taken over by regulators. The Bank got into a widening crisis following the collapse of SVB and Signature Bank, with wealthy clients withdrawing deposits and leaving the bank to struggle.
When asked about his assessment of the implicit guarantee and whether it was the right thing to do, Rajan expressed concern that no authority now has the backbone, or the risk tolerance, to see what happens if they let entities fail.
The former governor warned that the world has entered the zone of riskless capitalism, where entities take all the risks they want, so long as they take it collectively. Neither the Fed nor the Treasury, nor their equivalents in other countries, have shown the willingness to see entities fail, and this could lead to a Lehman-like moment.
Rajan said that the broader problem is that entities make money in normal times by taking risks, and then throw the risk back to the government in bad times.
The government and related authorities have not shown any willingness to tell people they must bear the risk they took. Equity holders got wiped out, but the uninsured depositors got a free pass. Rajan agreed with concerns that banks will be the first domino, with brokerage houses, asset managers, and even private equity facing potential destabilization due to duration mismatch and mark-to-market losses.
The former governor Raghuram Rajan highlighted that the tremendous period of low-interest rates and the search for yield has undoubtedly created some situations of extreme duration mismatch. The question is whether the equity of the institution can absorb these mismatches or whether they will play into runnable debt?
Rajan said that a major bank CEO, who was well-positioned to know where the flows were, had told him in October-November last year that “I think this stuff is going to happen”.
Rajan’s concerns are not unfounded, as evidenced by the recent failures of several US banks, including Silicon Valley Bank, Signature Bank, and First Republic Bank.
It is worth noting that Rajan’s views are not unique, and many experts have been warning about the potential risks in the world’s largest economy. The recent failures of several banks and the escalating inflation rate are just two examples of these risks.
