The Fed has financial stability as one of its three targets for monetary policy (inflation at 2% and full employment being the other two of course). All other central banks are less explicit but mimic the Fed when push comes to shove. The odds of the financial system’s instability overriding inflation concerns have risen appreciably.
Inevitably, a regional US banking issue with two banks gone and then a major global bank merged hurriedly in Switzerland has raised the spectre of a rerun of the GFC (Global Financial Crisis) and resultant financial instability that risks a harder landing and an undershoot in inflation.
However, a tightly regulated big banking sector has created a far more stable financial system, which, in the words of the Fed during the pandemic, has been a “source of strength, not weakness“. This may seem like an odd statement to make at the outset, but elevated market volatility due to fear does not simply mean that the banking system is weak.
Below are a few comforting and significant differences between where we are now and the GFC:
- The major banks are very well capitalised and have high levels of liquidity, including diverse deposits from consumers and companies.
- Balance sheets are less leveraged, and all major banks have a far better handle on risks and are far more transparent in showing the assets on the balance sheets. This was one of the key parts of the 3-Pillar redrawing of bank regulations post-GFC.
- Bad loan provisions have been raised in line with tougher macroeconomic conditions ahead of the expected macro downturn and ahead of the potential worsening in loan books.
- Stress tests for the biggest banks have played a key role in restoring confidence over the past decade.
- There are strict regulations surrounding the types of assets that count towards cash or near cash items, with the focus on short duration.
- Overall costs have been reduced significantly while revenues have increased thereby increasing the efficiency of banks.
There are areas of concern that may well weigh heavily on policymakers:
- The US regional banks have taken on extra risks as regulations were diluted and stress tests were watered down.
- There have been huge inflows into money market funds run by major banks such as JP Morgan as depositors look for safe havens.
- The regulations for liquidity management at regional banks were diluted, with Silicon Valley Bank (SiVB) an extreme case in the risks that were undertaken. However, the issue is that the Fed was unaware.
- US regional banks have also begun to dominate the real estate (both residential and commercial) market, which was already battling with a significant step up in interest rates and could face significantly higher levels of delinquencies.
- Loan practices were already being tightened and there is now a danger that the flow of capital to consumers and SMEs (small and medium-sized enterprises) will be compromised. This has already been seen in the tighter lending standards.
- Default rates for higher-yielding companies are still close to historic lows but will inevitably move higher as refinancing conditions get tougher for leveraged companies.
All of this results in increased economic risks for consumers and businesses, even as big banks maintain their solvency and strong balance sheets. The danger lies in the possibility that further efforts to implement more stringent regulations could ultimately lead to even tighter financial conditions, thus further undermining economic confidence. Both the Bank of England’s Governor, Andrew Bailey, and Michael Barr, the Fed’s Vice Chair of Supervision, have strongly hinted at the possibility of tighter regulations in the near future, while emphasizing the overall strength of the banking system. Although a full-blown banking crisis that affects large banks is unlikely, this does not necessarily translate to immediately calmer economic conditions or reduced market volatility.
To find more about the latest house views from London & Capital’s Investment Desk, read the full AndPapers Q2 2023 here.
 The three main pillars are: minimum capital requirements (Pillar 1), supervisory review (Pillar 2) and market discipline (Pillar 3).