Banking turmoil rattles markets, not central banks’ inflation-fighting resolve

Turmoil in the US and European banking sectors has drawn narrative parallels with the start of the global financial crisis (GFC) in 2007-08. Our US financial stability monitor (see figure below) shows worsening risk parameters, with measures of high-yield credit spreads and swaption volatility already reflecting lower liquidity and mounting stress. However, while there are signs of market tensions, the monitor also suggests we are not currently in a systemic financial crisis. Provided this endures, we expect that key central banks will retain restrictive stances and continue to raise interest rates, although at a slower pace than seen last year.

The creation of the Bank Term Funding Program (BTFP) in the US should help prevent failures of other small banks. It allows the Federal Reserve (Fed) to add liquidity to distressed banks as a “lender of last resort”, which should help restore confidence in the sector. The Fed has also opened daily dollar swap lines with other central banks as a USD liquidity backstop, which eases the risk of potential currency mismatches for USD borrowers overseas.

However, we would not underestimate the second-round hits to confidence on smaller banks and non-bank financial intermediaries, as these are significant to the overall financial system. For example, small US banks account for roughly 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending, and 45% of consumer lending.¹ A potential cumulation of US small bank defaults is therefore a key concern. Given the higher risk premium and subsequent higher funding costs facing the banking sector, a further tightening in credit conditions may reduce US GDP growth by 0.5 to 1.0 percentage points (ppt) in the coming quarters, and by 0.3% in the euro area. The extent of growth retraction will depend on the severity of contraction in bank lending.² Meanwhile, non-bank financial intermediaries (NBFIs) own almost 50% of total global financial assets (as of 2021).³ Forced selling by NBFIs amid a rush of investor redemptions and margin calls could raise market instability like that seen in last autumn’s UK pension funds gilts crisis.⁴ However, even as financial market woes will impact insurers’ investment portfolios, their asset-liability management operating framework means they are duration matched,  and their “long liquidity” business models implies they are not vulnerable to rapid withdrawals like banks.

Uncertainty remains high in this environment, and we see downside risks for economic growth, which could in turn slow inflation. The odds of a hard landing have risen, as a further tightening in bank lending standards and financial conditions would lead to lower demand, and ultimately lead to a potentially higher rate of corporate defaults and more bank risk aversion. Further, the latest central banks’ commitments to bring inflation down to target despite financial market instability should keep long-term inflation expectations well-anchored.

Financial markets have repriced for lower terminal rates as the policy trade-off of fighting inflation versus financial stability has become more challenging. In our view, central banks will use separate tool kits to address inflation versus financial instability concerns, and thus continue raising interest rates, albeit at a slower pace. This is because of the current high inflation environment, which contrasts to prior years of financial stress when central banks cut policy rates (eg, annual average CPI in the US stood at just 2.9% in 2007 when the Fed cut interest rates). Today, core CPI alone is at 5.6% in both the US and the euro area. However, if a systemic crisis were to develop, central banks could fall subject to financial dominance and cut their current tightening cycles short, prolonging the fight against inflation. In turn, this could potentially necessitate renewed aggressive tightening in the medium term, threatening greater volatility in financial markets and a sharper economic downturn.

___Swiss Re institute