The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
Let’s start with the good news. The flashing red light resulting from a speed-of-light run on the US banking system, or what economists broadly refer to as financial contagion, is behind us.
Yet it is too early for policymakers to declare mission accomplished. Instead, red has become a flashing yellow due to the slower-moving economic contagion whose main transmission channel, that of curtailed credit extension to the economy, increases the risk not just of recession but also of stagflation.
Poor risk management and inadequate business diversification were at the root of the bank failures. They were exposed for all to see by two factors: first, a mishandled interest rate cycle that saw the US Federal Reserve start raising rates way too late and then be forced into a highly concentrated set of hikes; and second, as remarked to Congress by vice-chair Michael Barr in an unusual episode of frankness and humility from the current Fed, lapses in supervision and regulation.
The risk of a generalised deposit flight from similar — regional and community — banks was material, especially as, immediately following three bank failures (Silicon Valley Bank, Signature and Silvergate), a fourth (First Republic) found itself on the ropes. The combination of unlimited deposit insurance for failed banks and a partial bailing in of large banks to help First Republic helped stop the deposit panic. Yet it is shock abated but not eliminated.
Smaller banks have suffered significant outflows of deposits to their largest peers — which depositors deem too big to fail — money market funds and, to a much less extent, the crypto space. They are unlikely to be fully reversed any time soon. Instead, they will force an adjustment by institutions that are big providers of loans to small- and medium-sized businesses, as well as mortgages. As these banking activities are unlikely to be undertaken at any scale by the beneficiaries of deposit outflows, system-wide credit will contract.
This is not the only contractionary impulse on the economy due to the banking tremors. Regulation is likely to increase, and so is supervision, particularly on the part of a Fed that has been caught making yet another policy error and that can ill-afford any more. There are also three other considerations that will make the banking system as a whole more cautious.
First, the bank failures have alerted investors to overall losses on the system’s “hold-to-maturity” portfolios that nominally amount to more than a quarter of the capital. If forced to realise such a loss through significant deposit outflows, the banking system itself would end up with a pressing capital hole. This comes at a time when other assets, such as commercial real estate, are already under some pressure.
Second, some banking models are now deemed a lot more fragile. In stark contrast to the 2008 global financial crisis, this applies to institutions that run more of a “narrow” banking model that has little, if any, investment banking component.
Finally, banks’ ability to pass on higher borrowing costs and larger fees for deposit insurance will be limited by the greater availability of alternative interest-paying products.
All this leads to the uncomfortable finding that we are on the cusp of a credit contraction that will play out over the next several quarters, probably reaching its apex towards the end of this year or the beginning of next year. It is a phenomenon that, unlike financial contagion, is not easily countered by policies.
The use of fiscal policy is constrained by political divisions and the concern that the tool was overused during and in the aftermath of the pandemic. Monetary policy needs to remain focused on curtailing inflation. Indeed, while the markets are pricing in both a cut in interest rates as early as June and an end-year level that is a whole percentage point below forward policy guidance, recent Fed commentary suggests that policymakers recognise this could be counterproductive as it would enable high inflation to persist. The recent Opec+ decision to cut output adds to this stagflation risk.
Success in dealing with the immediate threat of bank runs, as welcome as this is, has not eliminated the risk that the US banking tremors pose for the economy as a whole. Rather than bet on early rate cuts, markets should be encouraging the Fed to complete its inflation-reduction task before trying to offset a credit contraction that will only play out over a number of quarters. Failing that, we will be dealing with a higher probability of the even trickier challenge of stagflation.