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Credit Suisse's $39 Trillion Derivative Debt Poses Significant Threat to US Financial System.
Fed Must Continue Its Balancing Act.
Here is what we will be getting into today:
The Shadowy World of Derivative Debt: Why Credit Suisse's Troubles Spell Disaster for US Banks.
Navigating the Tensions: The Fed's Approach to Addressing Inflation while Protecting the Banking System.
Inflationary Pressures and the Looming Threat of a Hard Landing in the Global Financial System.
Let's Dive In!
Website: Wall Street On Parade
Title: The Next Bomb to Go Off in the Banking Crisis Will Be Derivatives
Here are the key highlights:
The U.S. Treasury Secretary, Janet Yellen, is under a lot of pressure due to the deteriorating condition of Credit Suisse, a Swiss banking giant. Under the Dodd-Frank financial reform legislation of 2010, Yellen was given increased powers to oversee financial stability in the U.S. banking system. The legislation made Yellen the Chair of the newly created Financial Stability Oversight Council (F-SOC), whose meetings include the heads of all of the federal agencies that supervise banks and trading on Wall Street. It is Yellen's authorization that would be required before the Federal Reserve could create any more emergency bailout programs for mega banks.
Recently, the US Treasury was reviewing US banks exposed to Credit Suisse, looking into how many billions of dollars of underwater derivatives US banks were on the hook for as a counterparty to Credit Suisse, and U.S. banks exposure to Credit Suisse's other major counterparties that U.S. banks do business with.
Credit Suisse was making headlines for two years, and serious problems at Credit Suisse have raised alarm bells in the US financial system. Credit Suisse is a global, systemically significant, too-big-to-fail bank that operates in the US and is deeply interconnected throughout the global financial system. Its failure could have widespread and largely unknown repercussions, which is why the US financial system and economy need to be adequately protected.
The recent revelations about Credit Suisse's deteriorating state have raised concerns about contagion risks in the banking industry, particularly in light of the staggering amount of secret derivative debt being held by foreign banks. According to a report by the Bank for International Settlement, this unreported exposure is 10 times greater than their capital, with an estimated $39 trillion of dollar debt held off balance sheets.
This poses potential threats to dollar swap lines and with a significant portion of derivative trades still not being centrally cleared, a layer of opacity is added to an already unaccountable system. The quarterly derivatives report from the Office of the Comptroller of the Currency found that four US mega banks held 88.6% of all notional amounts of derivatives in the US banking system, with a total notional amount of $195 trillion.
Title: SVB and the Fed.
Here are the key highlights:
The recent banking panic of 2023 in Silicon Valley brought to light the vulnerability of banks in the face of rising interest rates. The panic was quelled by swift government action, including the creation of a deposit insurance fund and a bank term funding program. However, the root cause of the panic cannot be ignored.
Banks were caught off guard by rising interest rates due to their heavy investments in long-dated government bonds, which decreased in value as rates rose, making them vulnerable to a run on deposits. To mitigate this risk, banks need to diversify their investments and be more vigilant about risk management. The government should also consider the impact of interest rate hikes on the banking system before making any decisions.
The stability of the banking system is critical to the functioning of the economy. The Federal Reserve has been increasing interest rates to curb inflation, but this move poses a significant risk to the banking system. Raising rates puts banks in a precarious position, making them more vulnerable to bank runs and financial instability. However, keeping rates low or cutting them could lead to losing credibility and letting inflation spiral out of control.
Central banks have the difficult task of balancing inflation, unemployment, and financial stability. Regulated banking systems are essential to curbing inflation, but they must also remain stable for the economy to grow. Failures or panics lead to disastrous public relations outcomes. The term "financial dominance" comes in when the central bank is afraid to raise rates for fear of destabilizing the banking system.
The Fed must find a delicate balance to address these concerns with inflation still above target. However, there is hope. The Fed has implemented new regulations and pro-stability measures to help shore up the banking system while still allowing for rate hikes. The Bank Term Lending Fund is an example of a tool that can provide liquidity to banks to help them manage a run on deposits. Flipside of this is that it may prompt banks to be more aggressive in their lending, leading to more demand and higher inflation rates.
The debate over whether to raise or lower interest rates is not just a matter of inflation versus unemployment but also raises concerns about financial stability. Both approaches come with risks, and the outcome is uncertain. Nevertheless, the US needs to find a way to balance these dynamics to prevent chaos in the financial system. Hopefully the pro-stability measures of the Fed can protect the banking system while still enabling the necessary steps to control inflation.
Newsletter: Macro Visor
Title: The no landing unicorns.
Here are the key highlights:
The current economic and financial resilience being displayed by markets do not indicate a 'no landing' scenario in the global financial system, but rather a 'hard landing' that will follow a period of tight monetary policy needed to control inflationary pressures.
With demand for assets and services remaining elevated and inflationary pressures continuing, the Federal Reserve and other central banks may need to tighten further than the market expects.
However, the Fed's habitual over-tightening and loosening policies have led to the creation and destruction of bubbles, and the current phase is the destruction phase, with the stakes being high. Consumer inflation expectations are rising, and the Fed has a lot more work to do.
Before concluding that there will be "no landing," it is important to consider the potential effects of unwinding the largest multi-asset bubble in human history amid a period of elevated inflation, as this would provide central banks with additional motivation to push further into an over-tightened monetary policy framework.
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*Picture Credit To Investopedia / Jessica Olah.
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