All eyes are on them. From regional bank failures in the United States to the bailout of Credit Suisse in Europe, central banks are expected at every turn in the crisis that has shaken the global financial system for the past two weeks.

The US Federal Reserve (Fed) has been at the heart of the action plan to guarantee deposits for customers of banks such as Silicon Valley Bank (SVB) or First Republic Bank and bail out troubled institutions as much as possible. The European Central Bank (ECB), for its part, has been making numerous statements in recent days to try to convince that Credit Suisse was an ugly duckling in a sea of strong and healthy European banks.

Raining money

Above all, they have reopened the liquidity taps to ensure that the banks' coffers remain well filled. "In the United States, for example, the Fed has already added $300 billion to its balance sheet since the beginning of this crisis," said Alexandre Baradez, financial analyst for IG France. Concretely, this means that the Federal Reserve is ready to advance without delay up to $ 300 billion in total to banks that would request it.

The world's main central banks – the Fed, ECB, Bank of England and the Central Bank of Japan – also agreed on Sunday 19 March to act together to facilitate access to dollar liquidity at the global level. "This is the same type of mechanism that was put in place after the collapse of Lehman Brothers in 2008 and at the time of the sovereign debt crisis in Europe in the early 2010s," notes Alexandre Baradez.

And the banks were not asked. In the United States alone, they borrowed $150 billion in just one week, between Thursday, March 9 and Wednesday, March 14. A rush for funds "which has no equivalent, even going back to the subprime crisis," says Alexandre Baradez. That is to say if there was a demand among American bankers, worried about being naked if all their customers wanted to withdraw their funds at the same time – as was the case with Silvergate or SVB.

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Above all, this "reaction capacity of central banks is phenomenal. This sequence proves that they really seem to have no limits in money creation to save banks they consider to be systemically important," notes Alexandre Baradez.

Perhaps they also feel a little responsible. These financial super-firefighters have indeed stepped up to the plate to extinguish a fire they helped to light a little more than two years ago.

Victims of Central Banks?

The context? The Covid-19 pandemic and the great unknown of its economic consequences. Faced with this unprecedented situation, "central banks have injected massive sums into the economy. It is thanks to the money they lent to states at very low rates that governments were able to put in place their emergency plans to allow their economies to survive the shock," said Alexandre Baradez.

Banks have had to adapt to this policy of low rates on short-term loans. "As these securities were no longer yielding, banks turned to much longer-term bonds, which remained more remunerative," notes Nathalie Janson, a specialist in financial issues at Neoma Business School.

This explains why all troubled U.S. banks in the U.S. had invested almost all of their assets in this type of financial product.

Except that this easy money policy has led to high inflation. And when central banks decided to bring prices to heel, they didn't go with a dead hand. They turned off the loan tap and decided to raise rates at an unprecedented speed. "This monetary tightening was more violent than the one started in 2014 to put an end to the easy money policy put in place after the subprime crisis," notes Alexandre Baradez.

"It was normal for this sudden turnaround to make victims among the banks," says Nathalie Janson. The rapid rise in interest rates over the past year has made short-term investments much more profitable for investors, who have therefore turned away from long-term bonds, causing them to lose a lot of value. As a result, "Those who had essentially long-term securities lost a lot of money, so much so that some went bankrupt," summarizes the Financial Times.

"Central bank policy has created a favorable context for this crisis, but institutions that have gone bankrupt have also made the mistake of not diversifying their investments to cover the risk of this rise in interest rates," says Nathalie Janson.

Fight against inflation or bank bailout?

Central banks' efforts seem to have paid off. Global stock markets rose again on Tuesday, suggesting that financial markets had digested UBS's emergency takeover of Credit Suisse and seemed reassured by the measures taken to bail out US regional banks.

But the hardest part may still be to be done. Inflation has not disappeared and central banks "risk finding themselves in the role of the pyromaniac firefighter unintentionally," says Nathalie Janson.

Indeed, after the operation "save the banking soldier", they could be tempted to resume the path of raising rates to contain the rise in prices. This is what the ECB has already begun to do on Friday, arguing that the battles against inflation and for financial stability can be fought head-on.

Will the Fed, which will decide this issue on Wednesday, and the Bank of England, whose decision on a rate hike is expected on Thursday, follow the ECB's example? "Above all, no further hike now," the German daily Süddeutsche Zeitung said in an editorial published on Tuesday. It is unclear whether there are other banks on the brink of a financial cliff that could fall in the event of further monetary tightening.

But the scenario of a prolonged pause in the policy of raising rates risks "installing central banks in an endless cycle of liquidity injection," said Nathalie Janson. In this scenario, the bank firefighter would add fuel to the fire of inflation. "And currently, we have no other solution to fight inflation than to use the leverage of key rates," says this specialist.

A refusal to raise rates "could also be interpreted by financial markets as a sign that central banks believe the banking system is still too fragile," notes the Wall Street Journal. Certainly not the message that central bankers would like to convey to stock exchanges that are just beginning to have confidence in the banking system again.

This is why "central banks will probably decide on a rate hike, but less than what we might have expected if there had not been these bankruptcies," said Alexandre Baradez. The bet, explained by the Financial Times, is that the banks, scalded by this crisis, will lend less money anyway, which will slow down economic activity and, quite naturally, lower inflation. But this is the dream scenario of a plan that would unfold without the slightest hitch.

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