Economy

The Great Inflation Unwind: Is the Breakage Just Beginning?

The postmortem on recent US bank failures brings home the reality of potential economic breakage as economies world-wide try to unwind from the inflationary effects of record covid stimulus, supply disruptions and a decade’s worth of zero interest rate policies. The inflation unwind portends serious market shocks of one degree or another as we just witnessed in both the US and Europe with bank illiquidity being triggered by severe asset price declines. Regulators and legislators are now assessing causes and are poised to address gaps in laws and regulatory supervision revealed by recent failures. 

The US Congress, and in particular, the House Financial Services Committee (HFSC), are a case in point. The HFSC recently kicked into high gear to assess recent banking disruptions and determine what actions to take, especially how to address the threats that technology and social media communications pose to the speed and potential contagion of bank runs. Similar efforts are underway in other key global markets which makes global coordination and cooperation critical in times of economic stress as we learned from the Great Financial Crisis.

In the US, the HSFC is a pivotal leader in the largest developed market in the world. Given the size of the US, many are watching what the US does to develop the process, tools and emergency response mechanisms needed for economic stability.

According to the HFSC website, the Committee covers such things as the economy, the banking system, housing, insurance, and securities and exchanges. It oversees the Federal Reserve Board (FRB), the US Treasury, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Office of the Comptroller of the Currency. With this broad spectrum of coverage, the HFSC’s postmortem review of recent bank failures in the US, including Silicon Valley Bank, Signature Bank, and First Republic Bank Corp are center stage. Here is where that stands.

Recent HFSC hearings included a notable line-up of banking and market regulators, as well as the former executive officers from the three failed institutions mentioned above. At best, it was a debate of competing narratives around who or what killed these banks. It was informative and serious, but not without partisan harangues over the many theories and “persons of interest” in these bank failures. In no particular order, committee members and witnesses identified several intertwined theories of where fault lies, including:

  • Politicians -- Congress weakened bank stress testing and other systemic protections in 2019;
  • Fiscal Policy Mistakes – government overspending and record stimulus forced unstable deposits on many banks who over-indulged in liquidity mismatch;
  • Monetary Policy Mistakes – the FRB’s misread on inflation forced unprecedented rate hikes causing asset price breakages like those observed at SVB and other banks; 
  • Bank Executives - incompetence and mismanagement by bank officials in assessing, testing and managing interest rate risk; 
  • FRB Bank Examiners -- who failed to monitor and aggressively compel liquidity improvements at these three banks; and,
  • The Internet -- The breadth and speed of communications on the internet and social media enabled the fastest, largest and most targeted run on bank deposits in history.

Most of these causes, including several not mentioned (e.g., accounting valuation standards), contributed in some fashion to the dire outcomes experienced by these US banks. More importantly, they provide a road map on potential risks and gaps in regulation. As such, we urge policy action in three areas:

  1. A clear-eyed assessment as to whether current US law (in the form of the Dodd Frank Act), as amended, still ensures proper and adequate capital, leverage and liquidity requirements for any bank that is big enough to cause systemic contagion.
  2. A thorough analysis on whether banks with more than $100 billion in assets should be subject to more thorough supervisory review, stress testing and resolution planning requirements. 
  3. A complete rethink on how bank supervisors must design new circuit breaker rules that can modulate the speed of technology/social media induced runs, giving banks and regulators needed time to address and correct imbalances.

What matters now is for the US to coordinate globally, get it right and get it done. Given the gravity of these recent bank failures, it is a moment for bold and timely action. Political quarreling must yield to the serious work of ensuring market safety, integrity and keeping pace with technological innovation. The impact of the Great Inflation Unwind is just starting – and it will not wait around for political gridlock to clear.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Paul Andrews

Paul Andrews is Managing Director for Research, Advocacy, & Standards for CFA Institute. Paul is also a current member of the CFA Institute Systemic Risk Council. Previously he was Secretary General of the International Organization of Securities Commissions (IOSCO) where he served two terms.

Read Paul's Bio