(Bloomberg Opinion) -- Everyone knows that the effects of interest-rate increases come with a time lag. It’s tempting to think it’s like pressing the brake in a car: Central banks push the pedal a bit, then a bit more and eventually the economy steadily starts to slow down.
The turmoil in banking this week shows this is the wrong analogy. Monetary policy is more like an elastic band: You can pull on it for ages and nothing seems to move until suddenly the other end comes pinging right at you.
This realization will have implications for what the Federal Reserve should do next. But it also underscores something else: The supposed choice between worrying about inflation or financial stability is false. Banks are still a crucial channel for monetary policy to be transmitted to the economy through their lending. At a certain point, bank stability is monetary policy. The US has reached a moment where monetary tightening is accelerating like a slingshot through the banking system.
This is working through banks’ expected profits and risk appetite. Both are changing dramatically. The deposit flight that bought down Silicon Valley Bank and Silvergate Capital Corp. happened as the cost of funding for banks had finally started to rise. Savers in the US and elsewhere didn’t react to higher interest rates for months in 2022, but they increasingly began to look for better returns on their cash late last year.
More people and companies began moving to higher-yielding alternatives like Treasury bills or money-market funds, reducing the cash in the banking system. Banks now must compete harder for funds, and they have quickly boosted the interest available on longer-term certificates of deposit, for example. Money market funds have just seen their biggest inflows since April 2020, while bank system-wide deposits shrank by $54 billion in the week before SVB was shut.
Those costs hit smaller banks first, squeezing their margins on lending. And while big banks might have gained some deposits initially at small banks’ expense, higher costs of funding will catch up with them, too. The Fed has been shrinking its balance sheet, sucking money out of the banking system; deposits can also shrink if people purchase new Treasury bills or put cash in money-market funds. In the past 18 months or so, money-market funds have been sending a lot of their inflows straight back to the Fed through its overnight reverse repo facility, which currently holds about $2.5 trillion. In the past year, total bank deposits have shrunk by about 3%, or $520 billion.
As depositors seek better yields and perhaps also move some money out of banks generally because of this month’s turmoil, the costs of all deposits will rise toward the level of rates set by the Fed. Big bank chiefs like Jamie Dimon of JPMorgan Chase & Co. were already talking at their full-year results in January about how they were going to have start jacking up returns for savers.
At the same time, the jitters spreading through markets have cut forecasts for how high interest rates will go. Central banks are now expected to reach peak rates sooner than they were a few weeks ago. That means less benefit to come for banks on their loans and securities holdings. A cap on growth in interest income alongside rising funding costs accentuates the squeeze on bank margins.
This dynamic is playing out in Europe, too, although not quite as quickly and sharply as in the US. But investors and analysts rowing back on earnings forecasts for banks is part of the reason that lenders’ share prices are falling. Since the end of February, the Stoxx Europe 600 banks index is down 16%, while the KBW US banks index, which includes many regional banks, is down 24%.
Alongside lower lending margins, there will soon be more troubled borrowers to worry about. Problems with late payments or defaults have been slow to appear in the past year because employment has stayed high and people had tons of savings left over from the pandemic. That is changing, too.
People are beginning to have problems keeping up with car loans and to a lesser extent credit card bills. Late payment rates on both prime and subprime auto loans that have been packaged up into asset-backed securities are both getting close to their recent peaks in 2016 to 2018, according to analysts at UBS Group AG. These are indicators of problems to come for banks, too. To be sure, banks will likely see loss rates rise back toward normal levels from a very low base rather than a wave of high stress. However, this will still cut risk appetites and tighten credit conditions.
Other kinds of lending are also looking shakier. Commercial real estate values are beginning to fall and US banks are more exposed to that market than they used to be.
The fear factor unleashed in finance this month has two affects. Liquidity has been the trigger and looks like the main pinch point. However, most dollars that are pulled from smaller banks and handed to big banks or the Fed via money-market funds, for example, can be recycled back to those smaller banks through the Fed’s discount window, its new Bank Term Funding Program, or private deals like the $30 billion of deposits for First Republic Bank. The more chilling effect is going to be on credit conditions, which will limit the borrowing available just as people and companies start to run out of all the spare cash they built up during the Covid pandemic.
The Fed has been trying to tighten financial conditions bit by bit for a year. It looks now like it is all finally happening — all at once.
More From Bloomberg Opinion:
- Fed Will Walk a Tightrope Between SVB, Inflation: John Authers
- A Year In, the Fed’s Scramble Is Looking Costly: Jonathan Levin
- Credit Suisse Needs Friends Now More Than Ever: Paul J. Davies
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To contact the author of this story:
Paul J. Davies at [email protected]
