Global regulators are facing a dilemma: the objectives of monetary policy contradict the objectives of supporting financial stability. Useful conclusions for Bank of Russia policy can be drawn from this situation.
  |   Elizaveta Danilova, Malika Musaeva, Ivan Shevchuk

Risks to financial stability have once again come into regulators’ focus due to crisis-related events in the banking sectors of developed countries. The banking crisis in the United States (the collapses of Silicon Valley Bank, ranked 16th by assets, in March 2023, and First Republic Bank, ranked 14th by assets, at the end of April 2023) and the worsening problems of European banks (the collapse of Credit Suisse) serve as a reminder of how important it is to avoid excessive vulnerability in the financial system and the economy. They also warn us that contagion effects can play a significant role in the development of crises due to the increased interdependence of institutions and the financial markets.

Over the past decade, financial market participants have become accustomed to very low rates and forward guidance from leading central banks signalling that these low levels would remain for a long time. This has led financial institutions to pay less attention to interest rate hedging and effective balance sheet management. The new cycle of rate hikes aimed at containing inflation has therefore led to the materialisation of interest rate risk for banks.

This has led to a dilemma: on the one hand, further rate hikes are needed to fight inflation in the US and Europe, but, on the other hand, an increase in rates leads to an increase in interest rate risk.

Contagion effects due to problems in Western banks are significantly limited in Russia (as long as these problems do not threaten a global recession and a drop in oil prices), as the Russian financial market is largely isolated due to the impact of sanctions and currency control countermeasures. However, useful conclusions for our policy can be drawn from the situation in the global markets.

Causes of the banking crisis

As the Fed states in its report on the causes of the collapse of Silicon Valley Bank (SVB), the bank’s bankruptcy resulted from errors in management and supervision: the bank’s vulnerabilities had not been fully recognised both by the bank and its regulators, and lower-than-needed regulatory standards had been applied to the bank despite its significance and rapid pace of development. The vulnerabilities of SVB and similar banks are the high degree of concentration in the banks’ business models, the growing exposure to interest rate risk as rates rise, and the high dependence on uninsured deposits. In the case of SVB, the bank’s rapid growth in size and complexity, along with a slow transition to higher risk management standards, contributed to the slow identification of risks and delayed actions by regulators. The high speed of deposit withdrawals further aggravated the situation: social networks instantly spread fears of a bank run, and technology, in particular the development of online banking, allowed depositors to withdraw funds instantly. The bankruptcy of SVB called the stability of a wider range of banks into question.

During the week of the SVB bankruptcy (link in Russian) (8-15 March), depositors withdrew nearly $100 billion from deposits at all US banks. The largest outflow of deposits occurred in small and regional banks.

Why was there a distrust of banks and a flight of deposits in the US?

First, it was not certain which other banks had problems similar to those of the banks that had already failed.

Due to the particularities of accounting, not all interest rate risk losses are reflected in banks’ financial indicators (profits and regulatory capital). In particular, the negative revaluation of bonds is not reflected. Only the largest US banks are required to reflect the revaluation of investments as capital in portfolios available for sale, while the revaluation of bonds held to maturity is not reflected in either capital or profit and loss statements. Thus, losses related to the portfolio become evident only when closing positions to cover cash gaps. SVB, which did not survive the deposit flight, faced such a situation. Other regional US banks also faced deposit outflows on the back of negative news of deteriorating financial stability. In late April and early May, a second wave of panic set in due to the collapse of First Republic Bank, which was placed under external management by the US Federal Deposit Insurance Corporation and then merged with JPMorgan Chase & Co. The stock prices of many US regional banks, including Pacific Western, Western Alliance, and Valley National, are falling.

Second, the US regulators have mostly focused on addressing the liquidity shortage rather than supporting the capital of troubled banks.

For example, the Fed has launched a new one-year refinancing mechanism secured by assets valued at par. According to the plan, this mechanism should free banks from the need to sell securities during liquidity shortages and to fix losses. However, this does not solve the problem: banks still hold lowyielding assets and must pay high market interest rates to attract funds.

Finally, despite the measures taken, shareholders and bondholders remain at risk.

The US authorities decided to cover the funds of all depositors in the bankrupt banks, including uninsured funds, but bondholders faced write-offs and shareholders suffered losses. This creates potential contagion in financial markets, such as for the insurance companies, pension funds, and investment funds that have invested in the financial instruments affected.

The crisis in the US quickly spread to Europe, where Credit Suisse, one of the world’s largest banks, faced market distrust. Credit Suisse had been experiencing problems for the prior two years, incurring losses due to a series of failed projects. To prevent the bankruptcy of this global systemically important bank, the decision was taken to sell it to another Swiss bank, UBS, for only 3 billion francs. However, Credit Suisse’s debts, amounting to 17 billion francs on subordinated instruments, were written off. This has led to increased risks for the entire contingent convertible bond market, which amounts to $250 billion. These bonds were introduced after the 2008 global financial crisis to maintain a certain capitalisation. They helped investors enjoy higher returns, but also had higher risks, as they are intended to be written off in the event of bank trouble. In fact, the Bank of Russia plans to gradually minimise their use as a source of bank capital, considering that these instruments – and their write-offs – only boost volatility in a time of crisis.

The case of Credit Suisse has led to increased investor concerns about the stability of other large European banks. The decline in the value of leading European bank stocks has now slowed, but if the fundamental problems in the banking sector persist, there could be a further worsening of global investor sentiment. This is the source of the dilemma between the goals of reducing inflation and maintaining financial stability.

Although interest rate risk is partially offset by regulatory actions, raising or even maintaining rates at higher levels than they were in the past decade may lead to many more consequences.

Not only interest rate risk but also credit risk may materialise. For example, households and non-financial companies have accumulated sizeable debts during the period of low interest rates. These debts will need to be serviced at higher rates due to refinancing or to automatic increases of floating rate loans. Rising loan rates will lead to an increase in overdue payments, write-offs and portfolio reserves. Businesses and individuals with high levels of initial debt burden may be the most vulnerable if the situation worsens. Crisis symptoms may also appear in the residential and commercial real estate sectors of certain countries where overheating has previously been observed.

Another channel of contagion is the slowdown in lending growth at higher interest rates. This will have a negative impact on the dynamics of economic activity. Severe problems may arise in the non-banking financial system (link in Russian), which is less regulated than banks.

Vulnerability of Russia’s financial sector

In contrast with 2008, the events in the US and EU banking sectors have so far had little impact on the performance of emerging market economies, in part due to the unfolding deglobalisation and fragmentation. The set of systemic risks for Russia has also undoubtedly changed due to the materialisation of geopolitical risks last year. Significant new vulnerabilities have emerged due to sanctions. In addition, it is important not to lose sight of previous vulnerabilities and how they are transforming in the new environment.

The sanctions have had a significant impact on both the financial and non-financial sectors in Russia. One key channel of impact is the restriction of access to infrastructure for payment in toxic currencies. The yuan market is currently actively developing, but exposure to the risks of its concentration is also increasing. The share of currency pairs traded with the yuan reached 36.1% of the total volume of onexchange currency trading and 22.3% of over-the-counter currency trading by May. However, this market has lower liquidity, so transitory spikes in volatility may occur. In the event of a slump in income from exports in toxic currencies and a slow transition to imports in the currencies of friendly countries, the domestic currency market may experience temporary imbalances, given the decoupling of the Russian market from the international market. The restrictions imposed on correspondent relations in the currencies of unfriendly countries have led to a deterioration in currency liquidity and an increase in dependence on operations through particular foreign banks against the backdrop of the sanctions.

The influence of the sanctions on non-financial companies is gradually increasing. In the first half of 2022, their financial positions were relatively stable, but they are now being affected by a number of factors that could lead to an increase in the debt burden. These include the embargoes and price caps on crude oil and refined products, the export restrictions imposed on other goods (such as the high tariffs on aluminium), the increase in transportation costs due to the shift in exports to the East, higher capital expenses due to the forced transition to new suppliers, and increased costs of finding new markets and making payments.

The withdrawal of foreign investors from Russian assets and the corresponding M&A deals financed by bank loans, or the replacement of the intra-group financing provided by nonresident parent companies have led to an increase in the debt burden on both buyers and their target companies, and to additional risks for banks. There are also potential risks that the business prospects of the target companies will worsen due to the disruption of technological, production and logistics chains. The purchase of currency to pay for the shares sold may also put pressure on the currency market.

In addition to the new vulnerabilities, a number of previous vulnerabilities still remain.

First, the debt burden on households is growing. Unsecured consumer lending bounced back quickly at the end of last year. The share of consumer loans provided to over-indebted borrowers (those with a maximum debt burden of more than 80%) reached a historically high level of 36% by the end of 2022. This is why the Bank of Russia set macroprudential limits, allowing highly indebted borrowers to receive no more than a quarter of all loans, in order to limit the debt burden on households and ensure that the structure of unsecured consumer lending remained balanced.

Second, there exist imbalances in the residential real estate and mortgage lending markets. Under the new conditions, the housing market remains oversupplied, while the effective demand is decreasing. This is evident from the utilisation of escrow accounts. At the beginning of 2022, loans to developers for project financing were 110% secured by escrow accounts, whereas this figure was only 84% by the end of the year.

Attempts to support demand by subsidising interest rates in the primary housing market or through the various marketing programmes offered by developers have resulted in a price gap between the primary and secondary markets, which has reached 30%. Historically, this gap has not exceeded 10%. Clearly, these are risks for both individuals and banks. If borrowers find it necessary to sell their properties, they may not be able to do so at the purchase price. Additionally, in the event that a borrower defaults, the amount received from the sale of a property may be insufficient to pay off the mortgage loan. Banks also bear risks associated with the deterioration of mortgage lending standards and developers’ resilience.

Nearly 70% of mortgage loans for newly constructed housing are issued with down payments of 15%. However, the loan amounts exceed the actual value of the collateral because of the price difference between the primary and secondary markets and the surcharges provided by developers’ programmes. The share of mortgage loans issued to over-indebted borrowers is also increasing: borrowers with debt service-to-income ratios of more than 80% are receiving 44% of all loans.

Third, transfers of household savings abroad may also entail risks to financial stability. Previously the main channel for the withdrawal of savings was the purchase of foreign stocks. Many people are now transferring funds to their own accounts in foreign banks. From the beginning of 2022 to March 2023, transfers by individuals to their own accounts totalled 2.4 trillion rubles. These transfers are partly used to pay for trips abroad and for online purchases, but a significant portion of funds remains in accounts in foreign banks. As it stands, foreign investments made by Russian citizens may carry geopolitical risks, such as closing of accounts and the restriction of transactions by banks and brokers, especially those from unfriendly countries. The outflow of funds also means a reduction in the deposit base of domestic banks.

Finally, there are interest rate risks for banks. Interest rate risk remains significant in view of several factors. The share of short-term funding remains high, with 78% of individuals’ funds and 92% of corporate clients’ funds in rubles being deposited for terms of up to 1 year or held in current accounts. Banks handle their interest rate risk mainly through the balance sheet method using the creation of assets with floating interest rates. This raises a question: how resilient are domestic banks to potential interest rate risks similar to those in the US? According to our estimate (link in Russian), the Russian banking sector will remain stable without regulatory easing even if rates spike by 500 bp.

Despite the current stabilisation in the banks of the US and the EU, the fundamental vulnerabilities of the global economy associated with interest rate risk still remain. When it comes to the Russian economy, the main challenge it will face in the coming years is the transformation of business models and adjustment to the new conditions while maintaining acceptable levels of borrower debt burden.