Recent bank failures revived fears of a full-fledged financial crisis and global recession – although economists have cautioned that the situation is not likely to lead to a repeat of the 2007-08 crisis.

The sudden collapses of Silicon Valley Bank and Signature Bank in the United States and Credit Suisse in Europe were blamed, in part, on rapidly rising interest rates.

The banking sector’s woes highlight the delicate balance facing central banks as they seek to tame high inflation without putting unnecessary stress on financial institutions.

What is the challenge for central banks?

Policymakers are walking a narrowing tightrope, trying to lower inflation on one hand, while keeping credit flowing through the financial system on the other. Ideally, regulators can raise interest rates at just the right margin and pace to bring price levels down without triggering a banking crisis.

The Issue for policymakers is that the main tool for suppressing inflation – high interest rates – can put added pressure on the banking system, which the entire economy relies on for credit flows, by reducing demand for loans. Increased turbulence in the banking sector makes a “soft landing” less likely and raises the risk of tipping the global economy into a recession.

Higher interest rates also make a recession more likely generally as they make it costlier for companies and households to borrow, encouraging firms to cut back on new projects and jobs and consumers to reduce spending.

In January, the World Bank reported that rapidly rising interest rates had brought the global economy to “a razor’s edge”, warning its worst-case scenario for 2023 was now its baseline. Last month’s banking collapses caused Goldman Sachs to raise the probability of a US recession in the coming year from 25 percent to 35 percent.

Inflation levels vary between countries, but prices worldwide are rising faster than before the pandemic.

According to the International Monetary Fund, global inflation levels are forecast to dip to 6.6 percent this year – down from 8.8 percent in 2022 – and further drop to 4.3 percent next year.

Inflation in the US was 6 percent in February, and the US Federal Reserve, whose rate changes are closely followed by other central banks, aims to bring it to 2 percent. Yet analysts have interpreted Fed Chair Jerome Powell’s recent softening tone as a sign the central bank is treading carefully.

“The Fed must now weigh up increasing rates, and risk more turmoil in both lending and the bank industry, against leaving them be or lowering them, which risks runaway inflation,” Tim Uihlein, a wealth manager and behavioural economist, told Al Jazeera.

What are the risks facing banks?

Higher interest rates pose several unique challenges for a bank’s business model.

For example, they make mortgage lending more complicated. Fixed-rate loans are immune to rate hikes, so banks can’t tap them to offset rising funding costs. While they can charge more for variable-rate loans, that increases the risk of a borrower defaulting, causing more losses.

As high inflation eats into savings, more people divert money out of banks to assets that can better offset rising living costs. Bank deposit rates in the US have dropped over 3 percent since monetary policy began tightening, with outflows accelerating during last month’s shock. In February, over 70 billion euros ($76.2bn) in savings left eurozone banks, the largest cash outflow on record.

Cash withdrawals on their own aren’t a cause for panic, but when compounded by falling bond prices, they can be a serious problem.

“Banks take customer deposits, and turn around to invest or lend their money for a greater profit,” Kevin Lao, a Florida-based financial analyst, told Al Jazeera.

“This exposes them to interest rate risk because as interest rates go up, the value of the fixed-income investments they purchased previously are now less valuable.”

Banks use bonds as a safe place to park savers’ cash. The yields then pay the depositors’ interest and earn the bank a profit. Yet rising interest rates have slashed the value of bonds over the past year. This only remains a paper loss unless banks have to prematurely sell the bonds off to come up with cash amid a surge in withdrawals.

Such was the case with Silicon Valley Bank, which announced it was short billions in cash due to untimely bond selloffs. Spooked investors then triggered a run on the bank, hastening its collapse.

“This incident shows that money is tightening as individuals and businesses tap into deposits that banks intended to invest for a longer time horizon,” Lao said.

More bank failures would raise the risks of financial contagion and the onset of a global recession.

What is being done to prevent a global crisis?

Institutions are taking precautions to stave off a potential credit crunch that could precipitate a worldwide crisis.

When last month’s collapses occurred, regulators in the US, United Kingdom and Switzerland moved quickly to facilitate takeover deals and guarantee deposits. Meanwhile, leaders in Brussels emphasised the strength of the European Union’s banking sector to reassure investors after Deutsche Bank’s share price took a dive on fears the major German lender could be next to fall.

Last month the US Federal Reserve enabled daily currency swaps with central banks in Britain, Japan, Canada, Switzerland, and the eurozone. Effective until at least April, the accelerated swaps, which are usually transacted on a weekly basis, aim to ensure its peers have access to US dollars to keep their financial sectors running.

These and other measures aim to stabilise any systemic shocks that may occur over the coming months.

More generally, the financial sector is widely considered to be in a better position to withstand shocks than in 2007-08 due to tighter regulation introduced in the wake of the crisis.

Among other regulatory changes, financial institutions are subject to higher capital requirements and stress tests designed to assess an institution’s ability to weather a serious economic downturn. (Al Jazeera)

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