Turmoil triggered by rising interest rates

At first glance, it seems that the demise of US lender Silicon Valley Bank (SVB) and the chaos in the pension markets following the catastrophic Liz Truss Budget are completely different episodes with nothing in common.

In reality, 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 point to the clear possibility of other unexploded bombs detonating further shockwaves in the banking system.

The powerful Federal Reserve, the US central bank, has raised interest rates to fight inflation, as has the Bank of England in the UK.

Now analysts expect the Fed, which was expected to raise rates again soon, will have to keep them on hold to support the global financial system.

At first glance, the closure of SVB in the US and the planned insolvency of the UK branch seemed more like a problem in the tech industry than the catalyst for a full-blown banking crisis.

Chancellor Jeremy Hunt and Andrew Bailey, the governor of the Bank of England, worked this weekend to find a buyer and were ready with a rescue package if that strategy came to nothing.

When a white knight showed up in the form of banking giant HSBC, they hoped it would draw a line under the turmoil.

But this is evolving into something bigger than a small local problem at a technology lender on the fringe of the global financial system.

The woes at the SVB are symptomatic of a much broader malaise as banks and businesses are shocked to adjust to higher interest rates.

Until the recent outbreak of inflation, the US and UK had become accustomed to stable prices and floor rates over a long period of time.

This mindset was encouraged by the printing of money, known as Quantitative Easing, which took place on an epic scale.

Collapse: At SVB, the American parent company went under because it had invested very large sums of money in US government bonds, the value of which had also fallen

But all that cheap money came at a high price. It caused massive disruptions, including bubbles in technology stocks.

These are attractive in a low interest rate environment, as investors are willing to place a bet on risky innovation in the hope of a decent return. But loss-making technology companies look a lot less attractive when interest rates rise.

Low interest rates also affected pension fund strategies.

Final pay schemes invested heavily in UK government bonds, known as gilts, to try and ensure they would meet their obligations to pensioners.

They also executed Liability Driven Investment (LDI) strategies in hopes of adding an extra layer of security.

But when interest rates rise, the price of Treasuries and government bonds goes in the opposite direction.

So LDIs unraveled spectacularly when interest rates suddenly shot up after 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 invested very large sums of money in US government bonds, the value of which had also fallen.

SVB has a separate balance sheet, but all banks, including the major British lenders, hold government bonds.

They are not as vulnerable as SVB because they have plenty of other assets, such as mortgages to homebuyers.

They are also less likely to have to deal with a customer flow, because their customer base is much more diverse than that of the SVB.

Since the crisis, major UK banks have been forced to have much larger capital cushions in case something goes wrong, and the Bank of England insists our system is robust.

But we’ve all heard that before in the financial crisis. When panic breaks out in banks, there is no room for complacency. Ultra-low interest rates certainly helped save our economy after the financial crisis.

They were intended as an emergency measure and instead became a way of life. Consequently, some companies, individuals and governments are very ill-placed for rates to rise to historically more normal levels.

Inequality became more extreme: the wealthy got richer, while low rates fueled the housing and wealth explosion. Tech bros became billionaires, at least in theory, from rising 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 will be a painful lesson.