For those of us in Parliament interested economic and financial matters, the last couple of weeks have been frantic. The sudden flurry of lobbying and activity from the tech sector over the failure of Silicon Valley Bank was only the beginning. Credit Suisse’s forced merger with UBS, and the difficulties with American regional banks demonstrate that the global financial system, of which London is a key part, is not in perfect health.
One phrase has hung over every conversation that I have had with friends and former colleagues who are active in financial markets – “Is this a repeat of 2008?”. I don’t think it is, and neither do most of the major players with whom I have spoken. The banks across the world are much better capitalised and more risk averse than they were in 2008. Yet things do feel decidedly uncomfortable, and there are several factors that policymakers must bear in mind as we move forward.
The fundamental reason that banks are having difficulties is very simple – when interest rates rise, asset prices fall. In the USA, interest rates have risen from almost zero to around 5% in less than a year, the sharpest rise since the Second World War. The Bank of England is not far behind. As such, the value of financial assets held by banks has fallen quickly, putting significant stress on the financial system. The impact of this rapid fall has left many banks vulnerable to unexpected demands for cash.
So where do we go from here?
We should first note that the UK regulatory system with regard to banks is in good shape. Our recovery and resolution provisions, combined with extremely high capital requirements for banks, mean that we can be very confident that our system can withstand any shocks without the British taxpayer losing out. Frankly, I think we have the best banking regulatory regime in the world – even if it is a little too highly taxed.
Yet there are many areas in which our broader financial regulatory system needs to be reformed, to ensure the health of our economy and our continued place in the global financial system. The Chancellor’s “Edinburgh reforms”, a package of measures set to improve the position of British capital markets and help promote innovation to the benefit of consumers, need to be enacted in full and built upon. There is much more to do. For example, we need to actually put into practice the reforms required to encourage British pensions funds to invest much more in British companies. Currently they invest less than 3 per cent of their assets in UK equities, compared with nearly half in 2000, an unsustainable position for one of the most critical parts of our economy.
The second key point is these market jitters are likely to cause a slowing down of the pace of – or even a halt to - interest rate rises across the world. This response would be understandable, as key sectors in Western economies struggle to cope with not just the interest rate rise, but the high level of interest rates themselves. This comes after a decade of nearly free money, with the total stock of British government debt growing to from around £1 trillion in 2011 to over £2.3 trillion in 2021 and private credit has grown quickly, hitting $1.4 trillion of assets under management globally at the end of 2022, up from about $500 million in 2015.
Reversal of the necessary policy to keep raising interest rates could see the spectre of inflation loom larger and longer than many politicians currently assume. The truth is that there is no easy route back to the world of cheap debt. Nor should there be. It hugely distorted allocation of capital, caused greater inequality (particularly between old and young), and exacerbated our endemic problem of low productivity. Inflation remaining higher for longer would have a profound impact on our politics. It would put more pressure on family budgets, hurt business and industry, and squeeze the British government’s ability to spend more on public services, with the interest paid on gilts falling more slowly than projected. As a government, we should use our domestic levers to bear down on inflation as much as we can, even bearing in mind the international headwinds. That will mean not carelessly cutting taxes in a way that stokes demand, while continuing to find more ways to loosen the labour market – The core items from Jeremy Hunt’s Budget of coaxing more over 50s back into work and making it easier for younger parents through childcare reform are a great way to start. Most importantly, we must further incentivise investment into the production of renewable energy here at home, reducing our dependence on global energy markets over time.
Nobody can know how badly the real economy, let alone the financial markets, will be affected by this sharp rise in interest rates. Yet if the difficulties that banks are facing with a severe fall in the value of their assets are reflected across the economy, then the coming years could prove perilous for our country. We must hold firm by holding down inflation, but keep making necessary regulatory reforms to our financial sector – which will help shore up our economy for the long term.
Article originally published on Financial News.
