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The Central Banks trade-off and the mechanism behind the pressure on the financial sector


A long news today - hope you like it :) !

A few days after the Fed rose the Fed’s fund rate by 25 basis points, I will focus on the difficult situations in which the Central Banks are.

The Economist recently published an article entitled “Central Banks face an excruciating trade-off” - a title that summarises well the situation. Indeed, as the financial sector seems to get weaker every day that passes, Central Banks face a very difficult trade-off between inflation control and financial stability.

Cutting interest rates would make the banks' lives easier but would also increase the risk of rising inflation. As nicely said in the Economist: “Central bankers already faced a narrow path to success. The ravines on either side of it have become deeper.”

So, I guess the question is what is happening to the financial sector and why? For what is happening to the financial sector, I would make it short as everyone that reads this probably already knows.

  • 10/03: Failure of the SVB after a bank run. The SVB had roughly $210bn of assets under management, which brings panic in the financial sector forcing the Fed to act, putting $25bn on the table

  • 15/03: Sharp decrease in the stock price of Credit Suisse – a bank that has been underperforming for a long time now – after the Saudi National Bank, the leading shareholder of CS, said it will not increase its participation in the bank.

  • 19/03: Swiss Investment bank UBS agreed to buy Credit Suisse for $3.2bn in a deal brokered by the government of Switzerland and the Swiss Financial Market Supervision Authority

  • 26/03 (date of the news): Many banks are under pressure, especially Deutshce Bank.

Now, the interesting question is why is this happening? (Simplified)

During COVID households put a higher proportion of their money in deposits as demand contracted and money was distributed directly to households by governments to help them in difficult times. The banks invested a large proportion of those deposits in the bonds market.

With the rising prices due to catch-up demand after COVID and problems in the supply chain after Covid disruptions coupled with the war in Ukraine (with Putin’s energy war), Central Banks rose interest rates to control inflation.

We know that when interest rates rise, the price of bonds decreases. Intuitively this is b/c the interest rate can be seen as the opportunity cost of investing in bonds. As bond prices decrease, the banks’ bond portfolio values also decrease. As a result, banks now face significant unrealised losses on these positions as well as withdrawing pressure b/c of the opportunity cost for households of having their money invested in low-return deposits rises with increasing rates .

FT: “Overall bank deposits declined $98.4bn to $17.5tn on March 15 from a week earlier, according to the Federal Reserve Data released on Friday afternoon”. “Separate data has shown cash rushed into money market funds in recent weeks, suggesting individuals and companies may be moving money from banks into ultra-liquid mutual funds, among other safe heaven investments.”

As people withdraw their deposits, it forces banks to realise their loss, putting the financial system under pressure.

Of course there are other sources of reserves (cash) i.e. other ways for banks to meet the deposit withdrawal requests than selling their securities (bond portfolios):

- The banks can borrow from the Central Bank in the standing lending facility (at the discount rate)

- The banks can borrow in the interbank market at the overnight rate (this requires trust between banks)

These other sources of reserves have also been more and more used in recent times (see graph below)

Note: This is the money that banks borrow from the FED. This graph was updated on the 30/03/2023 and we can see that demand of money has slightly decreased recently, which is good news as it means that the need for reserves of banks seem to decrease

With this in mind, let’s look at the market's short-term reaction to the 25 points hike of the Fed: “The higher bond prices accompanying stocks (see the yield table below as of three days ago) confirm the market message post ECB last Thursday - namely, that the markets like central banks focusing rates on the inflation battle and deploying other tools for financial stability.” Mohamed El-Rian

Although I agree with Mohamed El-Rian, I guess the “other tools for financial stability” that he is mentioning do not appear to be very reassuring for the market.

To see that such policy puts high pressure on the financial sector, let's just have to look at stock prices as of the day I am writing this (26th March): - 24th March stock price DB: -8.53% & rise in Credit default Swaps - 24th March stock price BNP Paribas: -5.27% - 24th March stock price Societe Generale: -6.13%

Quick look at the gold price - always interesting in inflationary periods & financial instability times:


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