It has been a frantic two weeks. The collapse of Silicon Valley Bank on March 10 sparked a domino effect that toppled another regional US lender, Signature Bank, spooked global markets, and led to the emergency takeover of Credit Suisse by UBS. Bank shares fell again on Friday, led by Deutsche Bank — prompting chancellor Olaf Scholz to insist there was “no reason to be concerned” about the German lender. Regulators and central banks appeared to have brought some stability this week, but it is still unclear if more dominoes will fall. The trigger for the turbulence — high interest rates — remains a threat; confidence is shaken and vulnerabilities in the banking sector could metastasise. It may not be over yet.
For starters, the fallout from the past two weeks is still being cleaned up. First Republic, another US regional leader, is still tottering and shares in similar banks are under pressure amid concerns that they, like SVB, hold lots of interest rate-sensitive assets. The UBS acquisition of Credit Suisse also has repercussions. The record of shotgun bank marriages is varied, and the giant new entity will take on even greater global importance. The structure of the deal — with convertible bondholders wiped out but shareholders receiving a payout — has made investors question the hierarchy of claims in the event of bank failures. Equity is usually junior to these bonds, though Swiss regulators say small print allowed this to be overridden. Legal battles are set to follow.
The authorities have acted to stem contagion in the banking sector. The US Federal Reserve’s generous liquidity scheme, concerted central bank action, and reassurances have helped. Remarks by US Treasury secretary Janet Yellen, however, sowed confusion over whether deposit insurance above the mandated $250,000 — as with the collapsed SVB and Signature Bank — would be in place if others fail, driving a sell-off in shares of smaller US banks. Interest rate risks loom beyond banks too: overleveraged sectors and investment funds with rate-sensitive assets remain exposed.
Those risks could yet intensify. With the battle against inflation not yet conclusively won, central banks need to nudge rates higher. Following its 25 basis point rise midweek, the Fed indicated one more rate increase in the pipeline; the European Central Bank has even further to go. The Bank of England also lifted rates by 25bp. Recent events are a reminder that rate rises do not feed through smoothly. Indeed, Fed chair Jay Powell implied fewer increases may now be necessary as the turmoil itself helps to tighten financial conditions.
Even if more banks are not toppled, there is a real risk of a broad credit squeeze. Higher interest rates have already slashed lending to the real economy, and banks are likely to raise their lending standards even further in response to recent events. Property lending appears particularly vulnerable. If credit tightens significantly, a spiral of falling prices and defaults is possible. In the US, the bulk of commercial real estate lending comes via the smaller lenders that are now under pressure. Those needing to refinance loans could face challenges. Mortgage-backed securities held by banks are already taking a hit, risking a self-reinforcing cycle.
For all the fears, a crisis on the scale of 2008 remains unlikely. Bank capital is stronger now, and failures have largely been due to idiosyncratic exposures and poor management. The authorities have been reassuringly proactive in offering support. Lending standards are better now too. But a tightening of credit is inevitable; how severe is unclear. And with the recent turmoil taking root in the less-regulated regional US banking sector, it remains possible that other vulnerabilities are lurking elsewhere. Rather than a blip, this episode could be a sign of things to come.