Thomas E. Woods, Jr., is the New York Times bestselling author of 11 books, including The Politically Incorrect Guide to American History and Meltdown (on the financial crisis). A senior fellow of the Ludwig von Mises Institute, Woods has appeared on MSNBC, CNBC, FOX News, FOX Business, C-SPAN, Bloomberg Television, and hundreds of radio programs... (Read More)

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Ask an Austrian Economist

2nd January 2013      by: Tom Woods     

We have a kind of “Ask an Austrian Economist” section at LibertyClassroom.com, and someone recently asked:

Peter Schiff has been very outspoken on his show on the idea that a large increase in the interest rates will lead to massive bank failures. He was critical of the stress tests the Fed ran earlier in the year on the banks because they did not assume interest rate hikes, which he felt would collapse the banks and prove that they were not sound. I never understood, however, why interest rate increases in our situation should lead to bank failures. Why would this be so?

The answer:

Rising interest rates will collapse the capital value (i.e., the market price) of assets banks hold. If they have existing T-bonds at 3% and interest rates on newly issued T-bonds rise to 6%, the price that investors will be willing to pay for the 3% bonds collapses. When that happens, banks become insolvent.

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  • Stan B

    Sorry..deeply flawed comment. Two sides to the balance sheet. Value of liabilities fall as well. And higher rates allow for higher net interest margins, which falls right to the bottom line. Your understanding of bank operations is incorrect…

  • http://tomwoods.com Tom Woods

    I’m not actually the Austrian economist the post is referring to. It’s Jeff Herbener, who elaborates further:

    “The bulk of bank liabilities are deposits, either demand or time. Their demand deposits are instantaneous and therefore, their capital value is unaffected by changes in interest rates. Their time deposits are not salable on secondary markets and so are carried on their books at “face” value. When interest rates change, then, the market value of the bulk of bank liabilities do not change. The bulk of bank assets are marketable securities or loans. Much of these do trade on secondary markets and therefore their value moves when interest rates change. Bank do hold some cash, whose capital value does not change with interest rates. But banks are highly leveraged from the issue of fiduciary media. Thus, changes in interest rates affect their assets to a greater extent than they affect their liabilities.”

  • A.J. Van Slyke


    This is precisely the reason why the FED will never let interest rates rise if they can help it. Not only would it collapse the large banks, it would also lead to hyperinflation because the FED itself is in the same position. Their “assets” are earning around 4% (since it is mostly long term treasury bonds) and their “liabilities” are costing them only about .25% (namely excess reserves parked at the FED). If/when the rates on the deposits they are paying interest on were to rise above those long term bond rates the FED would be caught in a net interest loss that they could never get out of. This will be the final bell that rings before we begin high inflation leading to hyperinflation.

  • Stan B

    Sorry..still Incorrect. Yes, deposits are fixed, but banks still fund themselves with senior/ subordinated debt as well. Do a quick google search on Bank of America and see how much interest expense they have saved by de leveraging and refinancing this debt at lower rates. Also, risings rates allow banks to issue new loans at higher rates, which falls straight to the bottom line. You (or your Austrian friend) assume all bank assets have a long duration and are sensitive to rate shocks. Simply not true. Assets roll off every day. Banks want (need) HIGHER rates otherwise there margins will continue to get crushed. You guys are only focused on one piece of the puzzle here and don’t have a complete understanding of bank operations.

    Long time reader, infrequent poster. Thanks for the response.

  • http://www.facebook.com/chris.handley.54 Chris Handley

    Perhaps I’m missing some of your points here, but I’m taking a look at the balance sheet of Bank of America, and it seems as though they are already quite close to both cash flow and balance sheet insolvency.

    Looking only at interest expenses as you suggested, the expenses have indeed been halved, but the interest income has decreased by roughly the same amount in nominal terms, so the net interest income has remained roughly the same since 2008. If rates rose fairly quickly and BOA had to suddenly start paying the same amount for deposits and short term debts as they did in 2008, and they were not able to originate new loans at the higher rates as quickly as people were willing to save their money, that would put some serious downward pressure on their earnings, which are already rather slim.

    I don’t think this is all that unlikely. People are not going to be as willing to take out loans as rates rise. In fact, people may not even be ABLE to since pretty much the only thing propping up significant portions of the economy is cheap credit. If that went away, so would a lot of jobs and we would be left with a repeat of 2008. Let’s also not ignore the possibility of defaults in this situation. If rates rose, and people couldn’t borrow and spend, there will be a lot of job losses, which will result in a spike in defaults. Well over 50% of BOA’s interest income comes from loans.

    On the Balance sheet side, looks like for assets, BOA lists about $900B in loan assets and $300B in security assets, around half of their assets, in 2011. Don’t see the composition for the loans, but if a significant portion of the loans are backed by anything with a value dependent on interest rates, like homes, then these “assets” could turn south rather quickly as the valuations drop. Same thing with the securities. If Treasury rates rise, those values drop as well. For Liabilities, I see about $700B in interest deposits and $340B in non-interest deposits, which is over half of their liabilities. If the economy tanks and people start keeping their money in banks, both of these liabilities could rise quite a bit.

    With assets falling and liabilities rising, interest income falling and interest expenses rising, I don’t really see where you’re coming from when you say that they have this analysis wrong. There is only a ~$230B dollar spread between assets and liabilities as it stands.

  • guest

    Paul Krugman said:

    Debt in a Time of Zero

    It’s true that printing money isn’t at all inflationary under current conditions — that is, with the economy depressed and interest rates up against the zero lower bound. But eventually these conditions will end. At that point, to prevent a sharp rise in inflation the Fed will want to pull back much of the monetary base it created in response to the crisis, which means selling off the Federal debt it bought.

    Peter Schiff said:

    Stress Tests No Sweat

    Despite endorsing phony economic data that shows the US is in recovery, the Fed knows full well that the American economy cannot move forward without its low interest-rate crutches. Ben Bernanke is trying desperately to pretend that he can keep rates low forever, which is why that variable was deliberately left out of the stress tests.

    Unfortunately, rates are kept low with money-printing, and those funds are starting to bubble over into consumer prices.

    Unless the Fed expects us to live with steadily increasing prices for basic goods and services, it will eventually be forced to allow interest rates to rise. However, if it does so, it will quickly bankrupt the US Treasury, the banking system, and any Americans left with flexible-rate debt.

    That is why the Fed feels it has no choice but to lie about inflation. If it admits inflation exists, then it may be pressured to stop it. However, if it stops the presses, it will bring on the real crash that I have been warning about for the past decade. Just as the Fed’s response to the 2001 crisis led directly to the 2008 crisis, its response to 2008 is leading inevitably to either deep austerity or a currency crisis.

    Imagine this scenario:

    When the banks fail as a result of higher interest rates, the FDIC will also go bankrupt. Without access to credit, the US Treasury will not be able to bail out the insurance fund – which only contains $9.2 billion as of this writing. So, not only will shareholders and bondholders lose their money next time, but so too will depositors!

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