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Trouble for the banks: what’s the big story?

The normally predictable banking sector has been catapulted into the headlines. Unfamiliar names such Silicon Valley Bank (SVB) and Signature Bank joined well known players such as Credit Suisse in facing collapse. Rescues and takeovers were swiftly arranged. Central bank governors and even the US president have provided reassuring words about the strength of the banking system. Amidst all the noise and confusion, we take a closer look at the banking sector.

Put simply, a bank uses depositors’ money to offer loans to customers wishing to borrow. Until these loans are arranged, the money can be invested in low risk financial instruments, earning the bank a return along the way. Trouble for banks such as SVB began when money invested in traditionally safe fixed income assets suffered well documented falls last year. If called to mark the value of these investments to the market price, SVB would have struggled to pay back all of its depositors. A bank is not usually asked to do that. But if depositors suspect that their money is not safe, they quickly ask to have it returned. That can trigger a run on the bank, as depositors’ confidence is irretrievably lost.

After rising steadily from October last year, the whole US banks sector took the hit. But not all banks will have the same problems as SVB, described as a ‘textbook case of mismanagement’. Large US banks are more tightly regulated than their smaller colleagues, which means they are more highly capitalised and better able to withstand shocks. They might also now benefit from a flight to quality, as bank customers switch their accounts to more trustworthy names.

Elsewhere, the stress felt by the sector might have wider knock-on effects. Mid-range US banks are crucial to their local housing markets, meaning individuals could struggle to get a mortgage loan. Much of President Joe Biden’s stimulus to invest in green technology, known as the Inflation Reduction Act, was expected to be financed by these middle tier lenders, who could struggle to meet a rise in demand for credit. A more general credit squeeze could impact economic growth, increasing the risk of recession.

Turmoil in the banks sector might seem alarming, but it could be that this cloud too has a silver lining. Fed Chairman Jerome Powell stated that recent events have served to tighten financial conditions, in the same way as a hike in interest rates. So much so that economists now forecast only a 30% chance of another rate rise in May, with speculation of rate cuts before the year end rising fast. Tighter credit conditions will likely also have a disinflationary effect, potentially knocking inflation off recent highs and making further rate increases unnecessary. Certain asset classes have thrived on the recent turmoil, among them gold, government bond markets, US money market funds and even Bitcoin.