Central Banks have tools to handle volatility in the banking sector

Read 3 min

Volatility in the banking sector, and therefore in most asset classes, continues. The situation with US regional banks is still developing and what we would argue as the disastrous decision by Swiss authorities to write down Credit Suisse’s AT1 bonds while paying shareholders off, has dented confidence in European banks. The situation remains fluid but we tend to think the way out of this problem could be coordinated central bank action to bolster confidence in the system. The issue with European banks and big US banks at the moment is confidence. It is not capital, it is not an increase in non-performing loans (NPL) and it is not poor liquidity ratios. Consumers are nervous because they see banks failing and they question whether these issues will spread to other banks and whether or not they should take their deposits out or sell their bank stocks. It is the job of central banks to safeguard financial stability and so the questions that come to mind are: Do they think they need to act? Do they have the tools? Are these tools enough?
On the first question, earlier this week Jerome Powell opened the Fed’s press conference with an introduction about the banking sector. He said: “In the past two weeks serious difficulties at a small number of banks have emerged. History has shown that isolated banking problems, if left unaddressed, can undermine confidence in healthy banks and threaten the ability of the banking system as a whole to play its vital role in supporting the savings and credit needs of households and businesses”. He then went on to explain the decisive action taken so far in coordination with the Treasury including the liquidity lines announced some days ago. In other words, the Fed (and the Treasury) have most definitely acknowledged that there is a problem in a small number of banks, that this problem needs to be addressed, and have already taken action accordingly. They have also highlighted that they stand ready to expand these measures and take new ones if needed.
Regarding the second question, after the experience of 2008 and Covid in 2020 we think that central banks have ample tools they can use to deal with localised pressure in the banking system. The ECB has innumerable liquidity facilities at their disposal which they’ve created through the years, some of which did not need to be used in size as the mere announcement of said facilities was enough to calm markets down. These are not only QE but also TLROs, Emergency Liquidity Assistance (ELA) and others. Also history shows central banks have the flexibility to create new facilities tailored to solve specific problems that surge along the way. On the other side of the pond the Fed has only recently created a new facility whereby they take eligible collateral at par for repo purposes for one year. Effectively if a bank is sitting on unrealised losses in a 10Y Treasury in their ‘Held to Maturity’ (HTM) portfolio they can get cash using it as collateral with no haircut. Given that part of the issue for US regional banks is in fact unrealised losses in HTM portfolios this just shows how flexible and customised new facilities can be.
Lastly, the answer to the third question has to do with what exactly is the nature of the problem. Is it that fundamentally the credit quality of the banking sector has deteriorated? A good summary of how financial ratios move over time are credit ratings. If we look at how Moody’s ratings for Western European financials have moved in recent years we find that there have been more upgrades than downgrades every single year, except for 2020, in the last decade. In other words the credit quality of Western European financials has been on an improving trend for nearly 10 years. Year to date we have 2.45 upgrades for every downgrade in the sector, Moody’s reports. One could question if central bank tools are enough to backstop a poorly capitalised banking sector, or one that has severe NPL problems. But we see no evidence of that. Consequently, it should be cheaper and easier to act fast, in size and hopefully in a coordinated manner so that those isolated banking problems that Jerome Powell referred to a couple of days ago are addressed and confidence in healthy banks is not undermined.
In conclusion, although we acknowledge the stakes are high, we do believe that the issues that some banks have faced in the last couple of weeks are isolated and that central banks have the willingness and tools to deal with these in order to stop the contagion that seems to be a function of confidence more than fundamental issues across the whole of the banking sector. In fact, we would not be surprised to see coordinated action announced before markets open on Monday. However, unfortunately damage has already been done over the last two weeks and we believe financial conditions will tighten as a result.





About the author