How will the banking turmoil affect the economy, policy and markets?

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Given the events of the last few weeks, it’s perhaps no surprise that the question I’m focused on this month is ‘how will the banking turmoil affect the economy, policy and markets?’.

The collapse of Silicon Valley Bank (SVB) and the rescue of Credit Suisse initially sent tremors through global asset markets. Governments and central banks have since created a fragile calm with speedy efforts to provide liquidity. This has helped contain risks of a rapid escalation, but there could yet be further reverberations.

In the US, the focus is on some of the other regional banks. SVB was an outlier in this group; it saw a ramp up in deposits in very recent years from venture capital (VC) funded businesses and invested these deposits in bonds at a time of extremely low interest rates. Problems emerged on both sides of the ledger as VC funding dried up and deposits were withdrawn, forcing the bank to realise the losses on the bonds it had purchased. A liquidity problem quickly became a solvency problem.?

What remains to be seen is whether the fate of SVB has damaged confidence more broadly in the regional banking sector. As we have seen so often before, it only takes one bad apple to spread the rot to the whole barrel. Even if deposits stabilise, these institutions might expect further, more stringent regulation which could affect their behaviour.?

To me, it seems highly likely that the recent turmoil will alter the behaviour of at least some of these regional banks. This is important. Regional banks account for 38% of total lending in the US economy and 70% of lending to the commercial property sector. If credit conditions – the price and availability of credit – were to tighten significantly in this segment of the banking market, growth could take a big hit. ?We don’t know yet by how much, but this is the chart to track.?

The European banking issues are slightly different. In the process of folding Credit Suisse into UBS, the former’s securities issued as additional tier 1 capital were wiped out before equity holders. This has raised concern about where these additional tier 1 instruments, also known as contingent convertible bonds (CoCos), sit in the capital stack. However, efforts by other European regulators to ease these concerns appear to have prevented further stresses in commercial bank funding markets.

Further volatility in recent days shows how all banks are being heavily scrutinised with investors looking for weakness in either their funding structures, security holdings, loan book and/or profitability.

I have wondered whether we should be concerned that the problem at the root of financial sector woes this time is not derivates, complex instruments or ‘toxic loans’ but government bonds – the supposedly ‘risk-free asset’. This asset is widely held throughout the financial system and the massive repricing last year has left unrealised losses throughout.

I think the problem can be contained as long as institutions are able to hold these bonds to maturity and receive the par value (of course this may be a loss in real terms, but at least not a nominal one). Policymakers must therefore maintain ample liquidity to ensure these bonds do not need to be sold. I believe this is well understood. The Federal Reserve’s (Fed’s) new term facility which allows these bonds to be deposited at par is the obvious example.

Importantly, I do not believe this is the start of a vicious cycle the likes of which we last saw in the Global Financial Crisis. It is important to recognise that the 2008 crash was the fallout from a real economy and banking boom centred around exuberant housing activity. Rapid house price increases fed a boom in construction in much of the US and parts of Europe. When prices started to decline, households facing negative equity often walked away defaulting on their loans. Construction stopped, unemployment in that sector soared, and the banks reeled in lending standards making the situation worse.?

We have not had a real economy or financial sector boom this past decade. The problem has, if anything, been an economy that was too sluggish. There is therefore no overhang in household debt and construction, nor has there been a boom in business investment and corporate debt. The need for a deep and prolonged period of weakness to work through past excess spending simply isn’t evident. Moreover, after a decade of increased regulatory scrutiny, large banks look to be better capitalised and have bigger liquidity buffers.?

My overall assessment therefore is that events of the last two weeks will impact commercial bank behaviour to a degree. Deposit rates will rise as banks compete to retain savers and this will push lending rates higher. Credit will be less abundant in some sectors of the economy but the aggregate effects will be relatively modest, particularly in Europe.?

It may however affect central bank behaviour in two ways.

First, it may mean that the commercial banks do some of the tightening work for the Fed and other central banks, perhaps resulting in fewer increase in interest rates. The Fed may have reached peak interest rates and the European Central Bank may be near. It could even get to the point where the Fed feels it needs to reduce interest rates to compensate. But that is not our core expectation just yet.?I am more worried about the UK’s inflation persistence and therefore am less sure the Bank of England’s work is done.

Second, I suspect central banks will become much more cautious about reducing their balance sheets. As discussed, we are now all acutely aware of the potential damage of unrealised losses on government bonds. Providing some degree of support to this market would be helpful. Regular readers of my work will know that I am not a fan of quantitative easing. The last few weeks are, in my view, yet one more demonstration of how difficult it will be to reverse given the unpleasant side effects of unconventional policy.?

My view at this stage is to hold relatively neutral positions until the outlook is clearer. For the reasons above, we do not envisage an escalation into a significant financial crisis. Particularly because you often get the boldest policy reactions when events appear most bleak. However, now is not the time for complacency.?

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