Market Turmoil Caused by Banking Instability Fails to Shake Central Banks' Determination to Combat Inflation, Says Swiss Re.

22 Mar 2023

There has been a lot of disruption in the banking industry lately in both the US and Europe. This has caused people to lose trust in the market. There's a higher chance that loans will be harder to get and that the economy will struggle. The silver lining is that this could help reduce inflation. We expect that central banks will continue with their current policy of being more strict, but they will do so carefully.

The banking industries in the US and Europe are going through tough times, similar to the start of the global financial crisis in 2007-08. A US financial stability monitor indicates that risk levels are getting worse; it measures high-yield credit spreads and swaption volatility to show that there is lower liquidity and increasing stress. But, even though there are signs of tension in the markets, the monitor assures us that we are not presently in any financial crisis of large-scale. So, it looks likely that central banks will stay cautious and maintain high interest rates, albeit not with the same speed as last year.

The implementation of the Bank Term Funding Program (BTFP) in the United States is expected to prevent the collapse of small banks. This program enables the Federal Reserve (Fed) to provide support to troubled banks as a "last-resort lender." It is hoped that this will help regain trust in the banking industry. In addition, the Fed has established daily dollar swap agreements with other central banks, which aims to mitigate the potential risks associated with currency mismatch for borrowers using USD overseas.

It's important to remember that smaller banks and non-bank financial intermediaries are crucial to the overall financial system. For example, small US banks are responsible for a significant portion of lending in various areas, including commercial, industrial, residential and commercial real estate, and consumer lending. If these banks were to default, it could have a major impact on the economy, leading to a decrease in GDP growth. Similarly, non-bank financial intermediaries own a large share of the world's financial assets, and if they were to be forced to sell due to investor redemptions and margin calls, it could cause instability in the markets. However, insurers are generally better equipped to handle financial market woes, as their business models are not as vulnerable to sudden withdrawals.

There is a lot of uncertainty in the current situation and we believe that the economy could suffer negative consequences because of it. This could lead to a decrease in inflation. We think it's possible that there could be a sharp decline in the economy, especially if banks start to tighten their lending standards and people have less money to spend. This could cause companies to default on their payments, making banks more hesitant to lend money. Additionally, the central banks' promise to reduce inflation even during times of financial instability should help keep inflation levels steady in the long run.

The financial markets have changed the way they value lower rates due to the struggle between fighting inflation and maintaining financial stability. We believe that central banks will use different approaches to deal with these concerns, and will continue to raise interest rates, though at a slower pace, because the current high inflation rate contrasts with previous years when they lowered interest rates. Today, core CPI alone is at 5.6% in both the US and euro area, whereas in 2007, it was 2.9% when the Fed lowered interest rates. However, if a significant crisis were to occur, central banks would prioritize financial stability and may pause their current strategy of raising rates, which could lead to greater volatility in financial markets and a sharper economic downturn. This could potentially result in renewed aggressive tightening in the future, making it difficult to anticipate the financial climate.

The Goldman Sachs report in 2023 defines small banks in the United States as those with assets below $250 billion and analyzes how stress in these types of businesses can affect the overall economy.

The blog post discusses two reports, one from Deutsche Bank and another from Goldman Sachs, both issued in 2023. The first report predicts a major shock to bank lending, which could lead to a recession. The second report examines the impact of this banking stress on the European economy. In simpler terms, the blog is about two different reports that came out in 2023. One report says that banks might not be able to lend money as easily and this could cause a recession. The other report talks about how this could affect Europe's economy.

In 2022, the Financial Stability Board released its third report on keeping track of non-banking financial intermediation on a global scale.

There are some potential dangers associated with leveraging, which refers to borrowing money to increase investments. In a recent speech, Sarah Breeden of the Bank of England addressed how even a small part of the pension industry can be a threat to financial stability.

Banking Chaos Shakes Markets, But Central Banks Remain Committed to Fighting Inflation

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