Economy 24 March 2023, 12:30pm

How dangerous is the current banking crisis? - Analysts assess situation

Portfolio

Despite serious market concerns, the current banking crisis is unlikely to spiral into a broader financial crisis, according to economists interviewed by Portfolio, who believe that the authorities have responded adequately and decisively to the problems that have arisen. The banking system is much more resilient than it was in 2008, and the situation of Silicon Valley Bank and Credit Suisse was unique, with no signs of systemic problems so far. Central banks should continue to focus on combating inflation, but also take into account the risk indicators of the financial system, as the contagion of problems in the banking system would have profound economic effects.

Bank collapses not seen for a long time

Two weeks ago, the bankruptcy of Silicon Valley Bank (SVB) and the closure of Signature shocked everyone, and the forced takeover of Credit Suisse by USB only added to the worries. The successive banking problems have raised concerns about another financial crisis, as the 2008 global economic crisis also originated in the banking system. Bank shares took a serious beating, expectations for interest rate trajectories in Europe and the US changed fundamentally, which also led to major shifts in bond markets, with yields falling.

The US Federal Reserve and the Treasury Department sprang into action quickly, and Credit Suisse was not allowed to fail by the Swiss authorities, so we have seen very swift and effective action in both the US and Europe.

In addition, the decision-makers argued that the situations of SVB, Signature and Credit Suisse were unique and that there were no system-wide problems. Nevertheless, there is not complete calm, bank share prices remain depressed, and the Fed believes that the problems of the banking system will have an impact on the real economy and inflation, and therefore it projects no further rate hikes. Uncertainty remains high, but analysts are not concerned about a new financial crisis erupting for the time being.

Is another financial crisis coming?

The risk of a systemic financial crisis is very low,

Zsolt Darvas, Senior Fellow at Bruegel and Senior Research Fellow and Corvinus University of Budapest, said in an e-mailed response to Portfolio's enquiry.

He reminded that the few financial institutions that faced troubles had specific problems. "Silicon Valley Bank had a risky business model and inadequate risk management processes. Credit Suisse was under pressure because of money laundering, corruption and spying scandals, made a big loss in 2022 and was expected to make losses in 2023 too," said Darvas. He also noted that Credit Suisse's annual report published in the midst of its crisis acknowledged material weaknesses in its internal controls over financial reporting and risk assessment processes.

"When deposits evaporated from Credit Suisse, other banks, including UBS and Deutsche Bank, reported unusually high deposit inflows, suggesting that trust in a few institutions was undermined, but not in the banking system as a whole, he said.

"Euro-area banks do not suffer from the problems of Silicon Valley Bank or Credit Suisse, while tightened banking regulation and bank supervision since the 2008 global financial crisis has made banks more resilient."

Padhraic Garvey, Regional Head of Research (Americas) at ING, is also relaxed about the possibility of a systemic turmoil.

So far the risk for a wider systemic breakdown is quite low,

he said.

"The Federal Reserve in the US has already undertaken extraordinary measures to help support sentiment, and the ECB felt emboldened enough to deliver a 50bp hike last week. A degree of calm has returned, but we continue to monitor the risks."

in other words, analysts do not find it likely that the situation will spiral into a financial crisis,

but both of them stressed that if the current situation were to escalate into a financial crisis, past experience suggests that this would have serious consequences for the European economy - but it is important to note that the chances of this happening are very small.

"The financial system is vitally important for the proper functioning of the wider economy, and especially the availability of credit at a reasonable cost of funds. Any breakdown in this has tended to correlate with sizeable recessions in the past," said Garvey.

Darvas said "an eventual financial crisis would certainly impact the European economy adversely, but [...] the likelihood of such a scenario is very low."

How will the macro path change?

After the SVB's bankruptcy, market participants significantly re-priced the expected interest rate path. A day before the event, interest rates were expected to be 5.75% by the end of the year, but after the banking problems surfaced, they fell to 4%, and are still at this level.

"For as long as central banks are comfortable that the financial system is functional and secure, they will continue to focus on the inflation fight. But it’s very much a two-pronged thing," said Garvey.

The system will always come first.

"With that secure and properly supported, attention can focus on inflation," he added.

Last week, the ECB hiked by 50 basis points and the Fed by 25 basis points, but forward guidance was markedly uncertain. The ECB did not provide any outlook, and while the Fed has promised in its rate forecast to maintain the current interest rate level until the end of the year. Fed chair Jerome Powell left the door open to further hikes in his press conference. The central bank's actions were therefore also affected by the news from the banking system, as inflation alone would not justify a halt to interest rate hikes in the future.

Monetary policy should not change because of some isolated banking problems. Inflation remains stubbornly high, and unemployment remains close to historical lows,

said Darvas, He pointed out that in its March forecast, the ECB improved its outlook for the labour market compared to its December forecast, and also raised its core inflation forecast for 2023 from 4.2% to 4.6%. While the forecast for 2024 core inflation was revised downward from 2.8% to 2.5%, the ECB made major forecasting errors in the past, undermining the trust in its longer-term forecasts.

"The 3% ECB deposit rate is still well below the current inflation rate of 8.5%, and also somewhat below forecast inflation over the next 12 months,

so there is scope for further monetary tightening.

What should we keep an eye on now?

There has been no similarly bad news from the banking system since Credit Suisse faltered. There have been problems with First Republic, where confidence has been boosted when it came to light that 11 of its rivals, including J.P.Morgan, Bank of America, Citigroup and Wells Fargo, would deposit $30 billion into the beleaguered midsized lender as part of the rescue. More recently, Deutsche Bank has been the subject of some concern. If further banks are affected, the market reaction could be violent, and the psychological impact could quickly trigger a wider banking crisis.

The critical issue is whether any other bank will suffer from mistrust and face large deposit outflows. This should be the primary issue to monitor,

said Darvas when asked what signs should we look for in the coming days or weeks to see more clearly about the development of the situation?

Market-based indicators, such as bank share prices and credit default swaps, are less informative in my view, because investors often react nervously,

he added.

According to Garvey, the obvious one is "any indication that other banks are under pressure."

That apart, at ING they like to look at the FRA/OIS spread, which effectively maps out where bank funding costs are versus the risk free rate. "So far this has been trending lower. Slowly, but in the right direction," he said.