Macro Insights: Banking sector dominos are falling

Key problem arises when a sufficient number of depositors lose confidence in their banks and start to withdraw funds. These actions of withdrawing funds can turn into a self-fulfilling prophecy and exacerbate a bank run. Ultimately, the survival of banks is determined not by their fundamental strength, but by the perceived safety among the masses who entrust them with their funds.

As banks seek to bolster their deposits, they face heightened competition for cash. Rising interest rates are making bonds, money market funds and other investments a more lucrative place for individuals and businesses to store their money. Meanwhile, banks also face a risk of impending regulatory overhaul.

Looming commercial real estate issues

The exposure to commercial real estate is one of the other worries that is keeping bank stocks under pressure, and can highlight which other banks may be at risk. Recently, Charlie Munger, Berkshire Hathaway vice-chair, has warned of a brewing storm in the US commercial property market, with American banks “full of” what he said were “bad loans” as property prices fall. The office segment is a particular source of risk, given the increasing remote and hybrid working options. Rising borrowing costs are also squeezing property owners, complicating the financing for many buildings. If these developers default on their debt, that could be a big blow to the US lenders exposed, and will have a more direct and quick ripple effect on the credit extension by the banks to the economy.

European bank lending survey flashing warning signs

The ECB’s Q1 2023 bank lending survey was also released yesterday, and highlighted that credit standards of Euro-area banks for loans or credit lines to enterprises tightened further substantially in the quarter and the pace of net tightening in credit standards remained at the highest level since the euro area sovereign debt crisis in 2011. Banks also reported a further substantial net tightening of credit standards for housing loans in Q1 2023. Slower lending was not just a factor of supply, but also weak demand. Firms’ net demand for loans fell strongly in the Q1 2023 due to high interest rates. While inflation, particularly from the services side, still remains strong, economic spillover concerns from the recent tightening seem to be increasing.

Liquidity outlook is worsening

Recent gains in the market have been somewhat driven by a sudden boost in liquidity, with central banks injecting about $1tn including the Fed’s response to Silicon Valley Bank crisis with new liquidity facility as well as Bank of Japan’s purchases of Japanese government bonds and ECB’s slow-moving QT execution. The US treasury drawing down its account at the Fed to the tune of $500 billion since late January – a source of liquidity that has now run dry as that account has dropped to sub-$100 billion levels. From here, there are risks of a pullback in liquidity as debt ceiling concerns rise and ECB ramps up quantitative tightening. A change in policy from the BOJ is also still likely. Some easing from China’s central bank may offset, but it will likely remain small and targeted.

Economic fallout risks

Regional banks in the US could continue to face deposit outflows. The below chart shows the sequential drop in deposits reported in the Q1 earnings. Even though risk of a systemic crisis is still low, keep a watch on which other regional banks could continue to face a threat of bank-runs.

Tighter lending standards also remain likely as banks turn more conservative in their business activities in the months ahead and try to retail capital. The Fed has already reported that commercial lending activity decreased sharply in the last two weeks of March, especially at smaller banks. The ECB has also hinted at the same. More widespread caution from banks can dampen business activity and increase the likelihood of recession. This would especially expose companies that are more dependent on funding.