Pausing rate hikes is key to stabilizing the banking industry – higher rates will collapse the financial sector

The global financial system is facing a crisis of confidence. Which makes this week’s meeting of America’s central bankers critically important. None of the 12 members of the Federal Reserve Board’s Open Market Committee were elected to their posts. The vast majority of Americans don’t even know their names, except perhaps for the chairman, Jerome Powell. But as they try to decide whether to raise interest rates and, if so, by how much, America’s central bankers are deciding on the fate of the American – and much of the world’s – economy. And they’re sitting on the horns of a dilemma. On one horn is their fear that inflation will become entrenched in the economy, requiring more interest-rate hikes. On the other horn is their fear that if they continue to raise interest rates, smaller banks won’t have enough capital to meet their depositors’ needs. Higher rates could imperil more banks, especially those that used depositors’ money to purchase long-term bonds when interest rates were lower, as did Silicon Valley Bank. That means that raising interest rates could cause more runs on more banks. The financial system is already shaky. The two objectives – fighting inflation by raising rates, and avoiding a bank run – are in direct conflict. As the old song goes: “Something’s got to give.” What will it be? The sensible thing would be for the Fed to pause rate hikes long enough to let the financial system calm down. Besides, inflation is receding, albeit slowly. So there’s no reason to risk more financial tumult. But will the Fed see it that way? The Fed’s goal last week was to stabilize the banks enough so the Fed could raise interest rates this week without prompting more bank runs. The Fed bailed out uninsured depositors at two banks and signaled it would bail out others – in effect, expanding federal deposit insurance to cover every depositor at every bank. On top of this, 11 of America’s biggest banks agreed to contribute a total of $30bn to prop up First Republic, another smaller bank caught in the turmoil. This “show of support” (as it was billed, without irony) elicited a cheer from Jerome Powell and the treasury secretary, Janet Yellen, who called it “most welcome”. (Of course it was welcome. They probably organized it.) But investors and depositors are still worried. Other regional banks across the US have done just what Silicon Valley Bank did – buying long-dated bonds whose values have dropped as interest rates have risen. According to one study, as many as 190 more lenders could fail. On Monday, First Republic remained imperiled notwithstanding last week’s $30bn cash infusion. Trading in its shares on the New York Stock Exchange was automatically halted several times to prevent a freefall. Multiple recent downgrades of banks by ratings agencies like Moody’s haven’t helped. Reportedly, the Biden administration is even in talks with Warren Buffett, the chairman of Berkshire Hathaway, who invested billions to bolster Goldman Sachs during the 2008 financial crisis. Central banks must ensure that instead of a race to the bottom, it’s a race to protect the public Meanwhile, on the other side of the Atlantic, the European Central Bank last week raised interest rates by half a percentage point, asserting its commitment to fighting inflation. Yet the higher interest rates, combined with the failure of the two smaller American banks, have shaken banks in Europe. Just hours before the European Central Bank’s announcement, the banking giant Credit Suisse got a $54bn lifeline from Switzerland’s central bank. Yet not even this was enough to restore confidence. After a several days of negotiations involving regulators in Switzerland, the US and the UK, Switzerland’s biggest bank, UBS, agreed over the weekend to buy Credit Suisse in an emergency rescue deal. Finance ultimately depends on confidence – confidence that banks are sound and confidence that prices are under control.