Quantitative tightening is a monetary policy instrument of increasing interest rates to tame increasing inflation and discourage borrowing by businesses and households. Companies will downsize to rein in increasing costs. This means unemployment will likely soar and cause social instability if the governments do not come up with intervention programs to mitigate poverty.
The opposite is an accommodation policy where the central bank lowers interest rates to encourage borrowing so as to stimulate demand and expand economic activities.
The adoption and implementation of these two central bank monetary policy tools depends on the economic environment existing in the specific country or globally.
The 2007-08 financial crisis and the Covid era prompted governments to implement an accommodation policy to cater for depressed demand and systemic paralysis in economic activities.
The early 2022 to the current period, we are seeing a world tightening regime to fight inflation brought about by a decade of low interest rates and the Covid era, which gave rise to excessive borrowing underpinned by relaxed underwriting standards by lenders chasing elusive risk premiums.
During the low-rate regime, banks loaned out a lot of money as can be measured by the Debt to GDP ratio to businesses and households. Interest service costs are manageable as long as the business deploys the loans to increase productive capacity to meet increasing demand.
The ability to service the debts was hamstrung by the effects of the Covid 19 era. In order to contain the virus, governments around the world implemented various measures. For example, China implemented a zero-covid policy which was a total closure of all businesses. Other countries implemented a partial closure of businesses and only allowed critical service businesses to continue operating within strict guidelines.
In order to mitigate the effects of Covid and the financial crisis, central banks injected liquidity into their economies by buying government bonds and other securities from banks. The result was excess cash on bank balance sheets to on-lend to the productive sectors and households. Some governments also borrowed from the International Monetary Fund due to inadequacy of revenue streams as economic activity had declined. This led to fiscal imbalances as interest costs became unsustainable to service the loans. It also led to exchange rate volatility risks as some loans were foreign currency dominated.
Interest rates play a big part in the overall earning capacity and capital structure of banks and companies.
Depending on the conditions of the loan agreement, some portfolios are structured with adjustable rates. They are then exposed negatively to positive movements in interest rates, unless the duration of the assets and liabilities is structured to minimize the negative effects on the capital adequacy and structure.
Quantitative tightening effects on Banks
Banks with fixed rate assets on their balance sheet will experience fair value losses due to the inverse relationship between interest rates and fixed rate assets. The tightening regime increases the probability of systemic risk. For the banks to minimize this risk, they either have to hedge their interest risk exposures through interest rate derivatives or they have to sell some assets early. Due to the costs of hedging, only part of the risk is usually hedged, leaving the banks still somewhat exposed. In addition, full hedging will likely eliminate all profits.
Some depositors looking for higher interest rates move their funds currently in bond portfolios to higher interest earning money market funds. In order to raise deposits, banks have to increase their deposit rates, and thereby reducing their profitability.
Leveraged positions increase their exposure during the tightening period and deleveraging has to be done earlier to mitigate systemic risk. This also applies to hedge funds who apply leverage to make profits, but this strategy is a problem in an increasing rate environment.
Banks must increase their loan loss provisions as the ability of customers to continually service their debts is constrained. In South Africa and elsewhere, most banks reported an increase in loan loss provisions in their financial statements this year (2024). There is credit migration from high quality graded debt to sub-investment and or even junk debt and to some extent, to defaults. This makes raising capital in the capital markets more costly as investors request higher premiums for the increased risk. Some banks with fragile balance sheets cannot continue increasing loan loss provisions, and hence they have to resize and restructure earlier, or they will fail.
Financial stability oversight entities and central banks worldwide will increase their surveillance and supervision to counter systemic risk within banks. This is necessitated by the interconnectedness of the banking ecosystem.
Quantitative easing effects on Banks
The US Federal Reserve Bank and the European Union reduced interest rates to near zero during the financial crisis of 2007-09 and the Covid era but this failed to stimulate the economy. Since there was no space to reduce interest rates further, they employed quantitative easing. They bought government bonds and other securities from banks so as to inject liquidity into the banking system. This gave banks ample liquidity to on-lend to the productive sectors of the economy, which has the following consequences.
Excessive borrowing
Due to low interest rates households and businesses load their balance sheets with unnecessary loans which do not support their strategic impetus and assets. Banks engage in poor underwriting standards so as to lend more money. Banks’ balance sheets will be loaded with poor loans which will not withstand adverse economic conditions.
Misallocation of financial resources
Funds end up being employed to undeserving sectors of the economy as the economic system is altered to cater for the low-rate policy. The demand and supply rules are no longer applicable.
Asset bubbles
Asset values are increased without a fundamental or underlying basis to support these values. This is because of increased competition for profits which are hard to find in the low-rate environment. As a result, companies and households end up entering a speculative bubble by investing in risky distressed debt.
Inflation creation
Too much money building up in the low-rate regime ends up creating inflation by bidding up prices of goods and services.
Policy suggestions and opinion
Forward-looking central bank analysis
The central banks must be proactive by adjusting their supervision and regulation with changes in bank risk profiles, complexity and changes in economic conditions. Fair value losses going forward can be estimated in advance and corrective measures applied before the risk materialize. As the interest rate increases, fair value losses also increase on fixed asset holdings on the banks’ balance sheet. Assumptions can be made in advance, taking into account individual banks where the fair value losses with deplete the required capital holdings beyond a certain interest rate. Immediate solutions can be found to contain this risk before it spreads to bankruptcy and contaminating the whole bank ecosystem and the economy at large, locally and even globally.
Bank resolutions and moral hazard
Previously, banks’ profits were retained by private shareholders, while their losses were potentially covered through bailouts by the government using taxpayers’ money. Bank boards of directors could therefore enter into risky lending as long as they knew in advance that a bail out was going to come from taxpayers’ money. I foresee directors being held accountable for risky lending that is not in the banks interests. Taxpayers will lobby the governments to do away with bailouts using taxpayers’ money unless negligent risk-taking is penalized and the bail out approved by relevant authorities. The best solutions will be to sell saleable assets to the right takers or to find the best banks with ample liquidity to take over problem banks.
Uninsured deposits
This gives rise to panic withdrawals, and I therefore argue that full coverage of all deposits will be created in the near future to create confidence in the banking system.
Already South Africa recently created the Corporation for Deposit Insurance (CODI) to protect qualifying depositors in the event of bank failures.
Financial literacy
I believe that the marginalized communities will, in the future, need to undergo financial education before being given loans. Banks should be mandated to educate these communities so that they are part of the inclusive and transformation agenda and stand to benefit from diversity and inclusivity policies.
