We are not in a banking crisis. Many developments over the past week have set off the spidey senses of those who followed developments in 2008. But the financial instability we have witnessed over the past week in the U.S. and Europe has been limited to idiosyncratic cases. We face a problem of liquidity (whether banks have the cash to meet demands from customers and counterparties) rather than solvency (when the value of the loans on bank balance sheets is called into question). There is a playbook for successfully tackling a liquidity crisis: the central bank steps in as a lender of last resort, as the Fed and the Swiss National Bank (SNB) have done. I have warned a number of times there would be market instability during a global central bank tightening cycle. While we are not in a banking crisis now, markets could make one happen. The financial instability we have seen so far will weigh on growth, which will hopefully help lean against inflation. The risk to the terminal interest rate for the U.S., UK and eurozone was overwhelmingly to the upside a week ago but now is more balanced.
I was reminded recently by a note put out by JPMorgan that we have a saying in economics: “Whenever the Fed hits the brakes, someone goes through the windshield.” It’s possible that Silvergate, Silicon Valley Bank (SVB), Signature Bank and now Credit Suisse (CS) have all been sitting in the passenger seat. I buy this argument for the small U.S. lenders, which were unusually exposed to interest rate risk and in SBV’s case didn’t bother to hedge for it. But just as the small regional U.S. lenders were idiosyncratic, so is CS.
CS has been in trouble for a while due to a number of factors—the interest rate environment not among them—and CS experienced significant capital outflows over 2022. With markets already jittery given bank wobbles in the U.S., CS suffered when the SEC queried its annual report on March 9 and the chairman of its largest shareholder, Saudi National Bank, ruled out raising any more capital for the bank on March 15. CDS spreads rose to levels not seen for a major international bank since the global financial crisis. CS’s tier 1 bonds (subordinate to all other debt) were trading below 80% of face value, a level that generally signals distress. But CS is not just a European version of the U.S. regional lenders that failed. It is much larger, has substantial high-quality liquid assets to call upon and is less sensitive to big moves in interest rates. According to the CEO, the firm’s liquidity coverage ratio showed it can withstand over a month of heavy outflows in a period of stress.
Just as the Fed (in conjunction with the U.S. Treasury and FDIC) stepped in as a lender of last resort for SVB and Signature Bank, the SNB extended a liquidity backstop of up to CHF 50 bn to CS. CS also announced it will buy back up to CHF 3 bn in dollar- and euro-denominated debt, which should squeeze the bond shorts that pushed the value of CS bonds way down. CS equities soared off the back of the announced measures.
While the failed U.S. lenders and CS are idiosyncratic, the overreaction of markets to developments feels very reminiscent of 2008 (to be clear, a lot is completely different from 2008—this is not a repeat of 2008). Bank runs are a question of psychology and Global Wall Street doesn’t seem to be in the mood to discern between idiosyncratic cases or between liquidity versus solvency problems. Just because we are not in a banking crisis does not mean we can’t land there in the end. Markets have a way of generating self-fulfilling prophecies. The liquidity operations that the Fed and SNB launched should be enough to stem the immediate panic. The S&P 1500 Regional Banks Index has stabilized (at low levels) and CS equities soared this morning before paring some gains.
What does all of this mean for the economy and central banks? Financial instability will feed through into the real economy through two channels. One channel is confidence, which is very difficult to measure, let alone predict. If everyone worries about a financial crisis and economic downturn, they will spend and invest less, the labor market will deteriorate and we could land in recession. The second channel is bank lending. If banks see deposits flee, their overall balance sheets will shrink, and they will extend fewer loans. Small- and medium-sized banks in the U.S. will almost certainly face more regulation going forward and they may begin complying with anticipated regulatory changes immediately, reducing their profits and constraining their lending. Banks may also pull back on loans as they anticipate financial instability will be a drag on growth.
According to JP Morgan and Goldman Sachs, a pullback in lending could shave 0.5-1 percentage points off U.S. GDP growth this year. That is in line with my view that the U.S. will enter recession later this year. But this isn’t necessarily a bad thing. Inflation came in surprisingly strong in February, with core services inflation and ex-housing accelerating on a monthly basis from January. Lower growth should take some heat off inflation. The Atlanta Fed’s GDPNow Index rose to 3.15% for the first quarter of 2023, which is well above potential growth of around 1.8%. This suggests that more demand destruction is necessary if the Fed is going to get inflation down to its 2% target.
Central banks have distinct tools for financial stability issues (supervision and lender of last resort capabilities) and macroeconomic stability (rate moves and the balance sheet). Given growth is holding up better than expected in the U.S., UK and eurozone and inflation is stubbornly high in all three regions, central banks arguably should continue to hike rates as they had planned to a week ago while using financial stability tools to address wobbles in the banking sector. But financial and economic conditions are intertwined and so there is a chance they might be more dovish.
The European Central Bank (ECB) was the first central bank to have a rate setting meeting after CS came under pressure. It stayed the course with a 50-basis point hike that it had signaled it would implement before the financial instability of the past week. The Fed and Bank of England will meet next week as well. I expect they will both hike interest rates by 25 basis points, which was also my forecast before the recent banking wobbles. One week ago, the risk on the terminal Fed Funds in this hiking cycle rate (which I forecast at 5.5%) was overwhelmingly to the upside. Now the risk is more evenly balanced.
The failed U.S. regional lenders and CS are idiosyncratic cases and there is no reason to expect they necessarily represent system-wide risk. So far, we are still dealing with a liquidity crisis and there are tools that can be (and have been) deployed for liquidity squeezes. Moves in Treasury yields have been dramatic over the past few days, but this is not 2008 all over again. In 2008, banks were under-regulated and undercapitalized. Their asset quality was in question, generating a solvency crisis. That said, the market overreactions we have seen in recent days raise the risk that investors will generate a full-blown banking crisis as a self-fulfilling prophecy. The recent instability will drag on loan growth and therefore economic growth. But with inflation stubbornly high in the U.S. and Europe and assuming a banking crisis does not materialize, this could be a feature and not a bug.