Financial markets around the world continue to shudder in response to the collapse and government bailout of Silicon Valley Bank (SVB), the near-collapse and cooperative bailout of First Republic Bank and now to the quasi-unlimited line of credit the Swiss National Bank (SNB, the central bank) put at Credit Suisse’s disposal. In response, investors small and large are reacting in seeming panic and seemingly indiscriminate zeal, shedding many (perceived) risky assets from their portfolios.
Those gyrations are once again raising the specters of “financial contagion” and widespread instability — and with them, renewed calls by regulators and (often opportunistic) politicians to restrain unruly financial markets, participants and institutions.
While some of these calls may be justified (for example, recent, excessive deregulation may have contributed to the latest banking debacle in the U.S.), it is important to interpret these events in context, that is, relative to our current understanding of how interconnected financial markets operate. Only then can we more clearly and calmly decide what the best regulatory steps may be.
First of all, what is financial contagion? This expression typically describes circumstances in which an initial shock (such as SVB’s default) rapidly propagates across multiple securities and markets (such as those of other, much more solid banks, as well as in European and Asian stocks), even those with no obvious relation to the original source of the shock.
Although it may appear unexplainable and illogical, contagion is often the expected response of the actions of rational agents in global capital markets. For instance, when some of their assets become riskier, risk-averse investors move out of them and out of any other risky ones they own into safer havens (Treasury bonds, cash, money market funds); all of their prices respond accordingly.
In addition, investors are aware that most banks routinely lend to and borrow from each other. These “interbank” transactions are both difficult to disentangle and likely to lead to powerful domino effects once even a single one of those financial institutions experiences distress: Which other banks will not receive payments that were due to them? Which of them will in turn not be able to fulfill their obligations to other banks? This is, for example, why Credit Suisse is currently deemed “globally systemically important” by regulators and was offered such a large line of credit by the SNB.
Finally, even isolated events end up igniting a reckoning among investors about the current extent of global financial risks. We call these events “sunspots” or “coordinating devices” because they lead investors to razor-focus their attention on risks previously ignored — even if they’re unlikely to materialize. As a result, right now, most banks around the world are experiencing sell-offs, since there is only limited transparency about their balance sheets and virtually no transparency about their domestic and international entanglements. The paradox of modern finance is that once investors are moving to sell, they become a near-unstoppable wave that realizes even their most far-fetched prophecies.
In brief, there is nothing that we have been seeing in the last few weeks that we have not seen before. This is comforting since it also means that wise and unchained policymakers (such as the Federal Reserve, the European Central Bank or SNB) know what to do about it, at least in the short term: provide (near unlimited) funding to most presumably healthy financial institutions to shore up their breakwaters; quickly liquidate and dispose of the weakest links in the banking network; shore up guarantees for small, uninformed or ill-informed depositors and investors; be transparent about the scope of the problem and of the actions undertaken to fix it; invite healthy banks to share more information about their risk profiles; act in a coordinated fashion across the globe.
Criticism of these actions as amounting to an unjustified, “woke” bailout of unworthy companies (or worse as rewarding individual or the elites’ bad behavior because of “moral hazard” considerations) are misplaced because the near-certain costs of inaction are much greater than its presumed benefits. Policymakers have an obligation to be realistic in order to serve the public good, rather than to pursue some poorly defined ideology and damn the consequences.
Global, interconnected financial markets have long provided incommensurable benefits to the world economy (and to all of us in it). But they come with their own set of risks and challenges. Old ideologies and blind moralism not only cannot help to tackle those risks and challenges but may make them much worse. Ignorance may be bliss, yet not today.
Paolo Pasquariello is a professor of finance at the Ross School of Business at the University of Michigan.