Banks continued to be the talk of the markets during the week. How can the European and US central banks respond to the challenges faced by the struggling banking sector?
Last week’s bank saga culminated with the Swiss banking giant USB buying Credit Suisse, which was on the verge of collapse, for more than three billion dollars on Sunday. The weekend-long rumour mill meant in practice that without the transaction, it would have been very difficult for Credit Suisse to continue its operations on Monday. The Swiss central bank and state have offered, among other things, 100 billion dollars worth of liquidity facilities and other guarantees to back the deal.
Although the deal dissipated fears about the consequences that Credit Suisse’s collapse might have had, the bank’s market value fell dramatically. This had an impact on the valuations of European and US banks, which fell in relation to the general index.
The debate about banks continued in the USA too. After the collapse of Silicon Valley Bank, it seems likely that the banking sector’s liquidity challenges are not over yet. The question now is whether the situation will evolve into a more serious solvency issue which would have an immediate and significant impact on both the US and the global economy.
The central banks play a decisive role in avoiding a crisis. The ECB held its interest rate meeting last week, raising its key interest rate by half a percentage point – as it had promised before banks started facing difficulties. Cancelling the rise would have sent a signal of panic, and the ECB’s President Christine Lagarde probably does not want to rock the boat any more than it already has been. The US Federal Reserve is due to hold its interest rate meeting this week, where it is expected to raise its key interest rate by 0.25 percentage points. However, it is highly uncertain how big the hike will ultimately be. The markets are also keen to find out what the Fed Chair Jay Powell has to say about the situation of banks – perhaps even more so than the information about the interest rate hike.
In the USA, commercial bank deposits started to decrease slowly but steadily already in 2022, which is exceptional, because normally deposits grow as central banks print more money for circulation. Especially smaller banks, such as SVB, have been leaning heavily on growing deposits as a source for their own financing, but now the return offered by money market funds, i.e. funds that invest in cash and other high-liquidity assets, has considerably increased while deposits have decreased.
There are at least two possible solutions to the challenges faced by banks. In the long term, banks will likely be forced to raise their deposit rates in order for the return on deposits to challenge the returns on money market funds and make money flow back into deposits. This is not a solution for the short term, however, which means that the central banks will probably have to intervene and offer liquidity to banks.
However, offering liquidity comes with a major problem: persistently high inflation. The Fed has reduced its balance sheet to curb inflation and is not too keen to offer large support packages to banks. On the other hand, the Fed will do everything in its power to avoid a full-blown banking crisis, which would be a bigger threat to the economy than inflation. The central bank’s balance sheet plays a key role in implementing the monetary policy, because controlling the interest rate level is based on regulating the banking system’s liquidity level. However, as a legacy of the 2008 financial crisis, central banks and other regulatory bodies have access to a wide array of other mechanisms to secure liquidity and solvency.
Banks’ difficulties have also had an impact on interest rates and credit spreads. The 12-month Euribor rate experienced two of the single biggest daily plunges in its history. Credit spreads have also grown: high yield corporate bond credit spreads grew by more than a percentage point and investment grade credit spreads by half a percentage point.
Technology companies and fixed income investments provided safety
The equity markets worldwide have reacted strongly to the difficulties in the banking sector. The traditional safe-haven sectors, such as health care, provided some safety, and as interest rates fell, so did the technology sector, specifically large blue chip tech companies.
At least temporarily, the ratio between fixed income and equity also seems to have returned to normal: as equities fell, fixed income investments picked up last week, balancing the overall situation for investors. Nevertheless, it is impossible to say whether this correlation will persist.
Nothing presented here is or should be taken as an investment recommendation or solicitation to subscribe for, buy or sell securities. When making investment decisions, the investor must carefully familiarise themselves with the information given on the financial instruments and understand the related risks. The investor must base their decision on their own assessment, goals and financial situation. Risk is always inherent in investment activities. The value of the investment instruments may increase or decrease. The past performance of investment instruments is no guarantee of future performance.