“Limited and gradual.”
Those are the three words repeated at nearly every speech or central bank press conference on the coming interest rate rise, after more than six years of near-zero interest rates.
Many people feel the economy is healthy enough and the big risk now is high inflation rather than falling growth.
But there’s one nightmare scenario that could play out, exposing a huge hidden risk in the heart of the finance industry. And it was just outlined by Kristen Forbes, a member of the Bank of England committee that makes the rate decisions.
Forbes said central banks should raise rates soon because “waiting too long would risk undermining the recovery — especially if interest rates then need to be increased faster than the gradual path which we expect,” she said in an interview with The Telegraph.
The banking system isn’t ready for that kind of shock. Global regulators have noticed and are worried.
It comes down to they way they calculate how much capital banks need, which absorbs losses in times of financial stress. Banks with enough capital survive and those that don’t lose the market’s trust and get cut off, either needing a bailout or a wind-down. So it’s quite important to get it right.
Here’s a chart of the biggest banks and their overall capital ratios from the US Office of Financial Research. The higher the ratio the safer the bank:
The global rules for working out the capital banks should hold in case of sudden changes in interest rates are 11 years old, and were set down way before the 2008 financial crisis and emergency central bank measures.
They’re loose, full of loopholes and different countries tend to do things their own way.
In June, the Basel committee on banking supervision, which harmonizes financial laws across the globe, said it would start to toughen those rules up:
First, to help ensure that banks have appropriate capital to cover potential losses from exposures to changes in interest rates. This is particularly important in the light of the current exceptionally low interest rates.
Excessive interest rate risk can pose a significant threat to a bank’s current capital base and/or future earnings if not managed appropriately.
The problem is that Basel rules can take years to agree on and are subject to intense lobbying from banks, so the new rules likely won’t be in place when the action starts happening.
It’s a Catch 22. Banks will complain that boosting capital comes at the expense of lending, which is something central banks don’t want to risk at time when they’re raising rates.
On the other hand, if banks blow up because they can’t handle what the higher rates are doing to their loan books then lending gets hit even harder and the global economy with it.
Either way, the US has signalled it may start raising rates as soon as next month, so the clock is ticking.