Social media tweets and immediate cell phone-activated deposit withdrawals meant banks collapsed quickly without warning. Silicon Valley Bank (SVB) fell on the 10^th of March, soon followed by Signature Bank. By the weekend, the contagion spread to Europe leading to the rescue and forced takeover of Credit Suisse. Nerves are still frayed. Another US regional bank, First Republic was taken over by a consortium of peers after its share price spiralled. However, authorities have moved rapidly to prevent a full-blown financial crisis.

Without hesitation, the Federal Reserve issued a guarantee to cover all the deposits of SVB. In addition, it created a $25 billion new lending facility, the Bank Term Funding Programme, to provide liquidity to regional banks in need. Banks would provide collateral in the form of US Treasury bonds, but the bonds would be valued at par value, not at the forced selling price that led to SVB’s collapse. In Switzerland, the Swiss National Bank provided a $53 billion credit line to Credit Suisse prior to arranging its takeover by Union Bank of Switzerland (UBS).

Should we be worried? Banks themselves are in infinitely better shape than they were in the 2008/09 Global Financial Crisis. Bank fundamentals have improved steadily over the past 15 years, guided by rigorous stress tests and more conservative internal controls. They are much better capitalised and have liquid balance sheets. Moreover, the debt servicing capacity of households and businesses is healthy, keeping non-performing loans at historically low levels. Households and businesses in the US and Europe have steadily deleveraged their balance sheets since the Global Financial Crisis and household savings are still well above pre-pandemic levels following the boost from Covid-19 relief transfers. Even if non-performing loans do rise, banks would manage as the industry’s reserve coverage ratio is at its highest in 40 years, capital ratios are sound and loan-to-deposit ratios are very low. According to stress tests, the systemic “too big to fail banks” are in good health.

In this cycle, bank failures have been idiosyncratic, caused by poor management rather than systemic imbalances. Banks have failed due to inadequate management of interest rate risk rather than rising credit risk, which would be far more serious. SVB’s failure was due to losses incurred on its US Treasury bond portfolio rather than credit defaults. Capital Economics Group Chief Economist, Neil Shearing concluded on the 20^th of March, “As things stand, we think that bank lending will contract in most advanced economies but that the feedback loop through rising credit risk (and a system-wide crisis) will be avoided.”

What are the implications for economic growth? Prior to the SVB failure, bank loan growth in the year to early March registered a robust 10.8%. Lending standards may tighten causing loan growth to decelerate, which would affect mortgage extensions, durable goods spending and business investment, but solid bank capital adequacy and reserve ratios should limit the impact. Economic activity was on a rising trajectory prior to the bank failures so could accommodate a slowdown without resulting in a recession. Global growth has rebounded in the first quarter of the year, likely to show a sizeable lift from the 0.2% quarter-on-quarter contraction in Q4 2022. The OECD predicts 0.5% quarter-on-quarter global growth in Q1. The global composite purchasing managers’ index increased sharply from 49.7 in January to 52.1 in February rising above the neutral 50-threshold for the first time since July last year, with gains recorded across most major economies. Forward-looking survey components indicate further improvement ahead. In the US, with households sitting on an amassed savings base exceeding $3 trillion, the outlook for consumer spending, which comprises over two-thirds of GDP, still looks strong. The crisis among small and mid-sized regional banks will undoubtedly slow growth but a recession remains unlikely. Goldman Sachs has raised its estimate of the probability of a US recession only slightly from 25% to 35%.

Bank failures are on par for the course during interest rate tightening cycles. The good news is that they tend to mark the end of rate cycles. The Fed, ECB and Bank of England were not deterred from hiking rates further in their post-SVB policy meetings. Even the Swiss National Bank, which one might have most expected to pause following the demise of Credit Suisse, hiked its benchmark rate by a full 50 basis points from 1.0% to 1.5%. Indeed, it raised its Swiss GDP growth forecast for 2023 from 0.5% to 1.0%, despite the domestic banking crisis. However, central banks will be led by the Fed in damping down their recent hawkish tone. The end of the rate hiking cycle is now in plain view. The softening in credit extension will help to bring inflation down and the threat to financial stability will raise policy makers’ concerns about over-tightening.

At the Fed policy meeting on the 22^nd of March, Chair Jay Powell said, “We’re looking at what’s happening among the banks and asking, is there going to be some tightening in credit conditions, and we’re thinking about that as effectively doing the same thing that rate hikes do… in a way that substitutes for rate hikes.” In some respects, the bank crisis is doing the Fed’s job for it. The large transfer of funds from bank deposits into money market funds, amounting to $120 billion over one week, is equivalent by some estimates to a 50-75 basis point hike in the fed funds rate. Yet, despite tighter credit conditions the Fed cut its GDP forecasts for 2023 and 2024 only slightly from 0.5% to 0.4% and from 1.6% to 1.2%, respectively. Fed funds futures point to a much lower trajectory for the benchmark interest rate. Currently at 4.75%-5.0%, the Fed funds rate had been projected two weeks ago to rise as high as 5.7% by mid-year. It is now projected to drop to 3.8% by year-end.

With the improving outlook for inflation and interest rates, the US treasury bond yield curve has become considerably less inverted. Prior to the SVB collapse 10-year Treasury bonds were yielding 85 basis points less than 2-year bonds. The yield gap has since narrowed to 40 basis points. There has been a constructive decline in 10-year yields, but 2-year yields have dropped even more sharply as markets sniff the onset of Fed rate cuts. This is good news for financial markets, with a recent surge in central bank liquidity providing the added impetus. The Fed’s balance sheet was gained by a massive $300 billion in the aftermath of the SVB collapse, a rate of liquidity expansion not seen since March 2020, at the onset of the Covid-19 pandemic. More liquidity expansion is predicted, which should feed through to higher financial asset prices.

According to independent research company MRB Partners, “The global economy didn’t need any help, but just received lower borrowing rates, a reversal (for now) of some of the paper losses on government bonds, lower energy prices and a near certainty that the Fed et al will not deliver a monetary knock-out blow for the foreseeable future.”