Professor warns of impending US banking crisis

Saying most banks are technically near insolvency with hundreds already fully insolvent.

Renowned economist Nouriel Roubini has issued a warning to the world: most US banks are technically near insolvency, and hundreds are already fully insolvent. The warning comes as US banks' unrealized losses on securities hit USD 620 billion, about 28% of their total capital. In addition, rising interest rates have caused banks' other assets to lose value, leading to unrealized losses of about USD 1.75 trillion, or 80% of their capital. This puts most US banks in a perilous position, and Roubini believes that hundreds are already fully insolvent.

The US banking crisis is largely due to the banks' highly foreseeable duration risk. Banks assumed this risk because they wanted to fatten their net-interest margins, seizing on the fact that while capital charges on government-bond and mortgage-backed securities were zero, the losses on such assets did not have to be marked to market. This highly risky strategy was taken without regulators subjecting banks to stress tests to see how they would fare in a scenario of sharply rising interest rates.

The consequences of this strategy are now apparent. Rising inflation in 2022 led to higher bond yields, causing ten-year Treasuries to lose more value (-20%) than the S&P 500 (-15%). As a result, investors with long-duration fixed-income assets denominated in dollars or euros have lost a lot of money. The consequences for banks are also severe. While the “unrealized” nature of banks’ losses is an artifact of the current regulatory regime, which allows banks to value securities and loans at their face value rather than their true market value, this regulatory regime may not save them.

The credit crunch caused by the current banking stress will create a harder landing for the real economy. The key role that regional banks play in financing small and medium-sized enterprises and households means that a banking crisis will have serious implications for the wider economy. This means that central banks face not just a dilemma but a trilemma. Achieving price stability through interest rate hikes raises the risk of a hard landing (a recession and higher unemployment) due to recent negative aggregate supply shocks. But this vexing trade-off also features the additional risk of severe financial instability.

Central banks confronting this trilemma are likely to wimp out, curtailing monetary-policy normalization to avoid a self-reinforcing economic and financial meltdown. However, this could lead to a de-anchoring of inflation expectations over time. Central banks must not delude themselves into thinking they can still achieve both price and financial stability through some kind of separation principle. In the end, it's the banking crisis that could put the global economy at risk.


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