Turmoil triggered by rising interest rates

More trouble ahead as era of cheap money ends

AT first sight, it may seem that the downfall of American lender Silicon Valley Bank (SVB) and the chaos in pensions markets following the catastrophic Liz Truss Budget are totally different episodes with nothing in common.

In truth, however, they both had the same trigger – the rising interest rates that came on both sides of the Atlantic after a long period of ultra low borrowing costs.

And both indicate the distinct possibility of other unexploded bombs that could detonate further shockwaves in the banking system. The mighty Federal Reserve, the US central bank, has been raising rates in order to combat inflation, as has the Bank of england in the UK.

Now, analysts anticipate the Fed, which had been expected to put up rates again shortly, will have to keep them on hold to shore up the global financial system.

At first blush, the closure of SVB in the US, and the planned insolvency of its UK arm, looked more like a tech industry problem rather than the catalyst for a full-blown banking crisis.

Chancellor Jeremy Hunt and Andrew Bailey, the governor of the Bank of england ( pictured), worked over the weekend to find a buyer and were standing by with a bailout package if that strategy came to naught.

When a white knight emerged in the form of banking giant HSBC, they must have hoped that would draw a line under the turmoil.

But this is evolving into something bigger than a little local difficulty at a technology lender on the periphery of the global financial system.

The woes at SVB are symptomatic of a much wider malaise as banks and companies need to make a jolting adjustment to higher interest rates. Until the recent outbreak of inflation, the US and the

UK had become accustomed over a long period to stable prices and rock bottom interest rates.

This mentality was encouraged by money- printing, known as Quantitative easing, which took place on an epic scale.

But all that cheap money came at a heavy cost. It fuelled huge distortions, including bubbles in tech stocks. These are attractive in a low interest rate environment because investors are prepared to take a punt on risky innovation in the hope of a decent return. But loss-making tech firms look a lot less alluring when rates rise.

Low rates also affected strategies at pension funds.

Final salary schemes invested heavily in UK government bonds, known as gilts, in order to try to be sure of meeting their commitments to pensioners.

They also ran Liability Driven Investment (LDI) strategies in the hope of adding a further layer of security.

But when interest rates go up, the price of gilts and other government bonds goes in the opposite direction. So the LDIs unravelled spectacularly when interest rates suddenly shot up following the Truss/Kwarteng Budget. That hit the value of gilts and threatened funds with the prospect of forced sales at a loss.

At SVB, the American parent company went under because it had put very large sums of money into US government bonds, whose value had also tanked.

SVB has a distinctive balance sheet but all banks, including the big UK lenders, hold government bonds. They are not so exposed as SVB because they have plenty of other assets such as mortgages to homebuyers. They are also less likely to suffer a run of customers, as their client bases are much more diverse than SVB’s.

Since the crisis, large UK banks have been forced to have much bigger cushions of capital in case things go wrong, and the Bank of england insists our system is robust.

But we heard all that before in the financial crisis. When bank panics start, there is no room for complacency. Ultra low interest rates certainly helped save our economy after the financial crisis.

They were meant to be an emergency measure, and instead became a way of life. As a consequence, some companies, individuals and governments are very poorly placed for a rise in rates to historically more normal levels.

Inequalities became more extreme: the rich became richer, as low rates fuelled housing and asset booms. Tech bros became billionaires, at least in theory, off the back of ballooning valuations that have now deflated.

At least one generation came to believe that low rates were a natural state of being and is learning that this is not the case. It is going to be a painful lesson.