Turmoil triggered by rising interest rates

At first glance, it may seem that the fall of US lender Silicon Valley Bank (SVB) and the chaos in the repo markets following Liz Truss’ catastrophic budget are entirely different episodes and have nothing in common.

In truth, however, they both had the same trigger – the rise in interest rates that occurred on both sides of the Atlantic after a long period of ultra-low borrowing costs.

And both point to the distinct possibility of other unexploded bombs that could send new shockwaves through the banking system.

Rescue: Chancellor Jeremy Hunt and Bank of England Governor Andrew Bailey (pictured) worked over the weekend to find a buyer for SVB’s UK branch

The mighty Federal Reserve, the central bank of the United States, has raised rates to fight inflation, as has the Bank of England in the United Kingdom.

Now, analysts predict that the Fed, which was due to raise rates again shortly, will have to keep them on hold to bolster the global financial system.

At first glance, the shutdown of SVB in the US and the planned insolvency of its UK branch looked more like a tech industry problem than the catalyst for a full-scale banking crisis.

Chancellor Jeremy Hunt and Andrew Bailey, the Governor of the Bank of England, worked over the weekend to find a buyer and waited with a bailout if that strategy failed.

When a white knight emerged in the form of banking giant HSBC, they must have hoped that would end the turmoil.

But this is evolving into something bigger than a small local difficulty at a technology lender on the periphery of the global financial system.

SVB’s woes are symptomatic of a much wider malaise as banks and corporations have to make an abrupt adjustment to higher interest rates.

Until the recent surge in inflation, the United States and the United Kingdom had grown accustomed over a long period to stable prices and rock-bottom interest rates.

This mentality was encouraged by money printing, known as quantitative easing, which unfolded on an epic scale.

Collapse: At SVB, the US parent company went bankrupt because it invested very large sums of money in US government bonds, which also fell in value

But all that cheap money came at a huge cost. This fueled huge distortions, including bubbles in tech stocks.

These are attractive in a low interest rate environment as investors are willing to embark on risky innovations in hopes of a decent return. But loss-making tech companies look much less attractive when rates rise.

Low interest rates have also affected pension fund strategies.

Late-pay schemes have invested heavily in UK government bonds, known as gilts, to try to make sure they meet their commitments to pensioners.

They also executed Liability Driven Investing (LDI) strategies in hopes of adding an extra layer of security.

But when interest rates rise, the price of gilts and other government bonds goes in the opposite direction.

So the LDIs crashed dramatically when interest rates suddenly shot up after the Truss/Kwarteng budget. This hit the value of the gilts and threatened the funds with the prospect of forced sales at a loss.

At SVB, the American parent company went bankrupt because it had invested very large sums in American government bonds, the value of which had also fallen.

SVB has a separate balance sheet but all banks, including major UK lenders, hold government bonds.

They are not as exposed as SVBs because they have a lot of other assets such as homebuyer mortgages.

They are also less likely to experience a string of customers, as their customer bases are much more diverse than those of SVBs.

Since the crisis, Britain’s big banks have been forced to have much larger capital cushions in case things go wrong, and the Bank of England insists our system is robust.

But we have already heard all this during the financial crisis. When the bank run begins, there is no room for complacency. Ultra-low interest rates certainly helped save our economy after the financial crisis.

They were meant to be an emergency measure and instead became a way of life. As a result, some businesses, individuals and governments are very poorly positioned for a rate hike to more historically normal levels.

Inequality got more extreme: the rich got richer, as low rates fueled housing and housing booms. The tech brothers became billionaires, at least in theory, on the back of skyrocketing valuations that have now deflated.

At least one generation has come to believe that low rates are a natural state and learns that is not the case. It will be a painful lesson.