Moody’s is out with a report on the banking crisis, lauding policymakers for their rapid response. At the same time, the research firm states that stress in the banking sector can spread to other sectors while outlining three different possible paths for contagion.
The banking crisis of 2023 is still blazing but the collapse of multiple banks could have been avoided. That much is clear. But what is on the horizon?
Moody’s segments’ current known risks for the banking sector going forward:
First, is the collateral damage or spillover effects on entities with direct or indirect exposure to wobbly banks. The report states:
“Financial and nonfinancial entities in the private and public sector could have direct exposure to banks via deposits, loans, other transactional facilities or holdings of the troubled banks’ equities or bonds. They could also be reliant on a troubled bank for the provision of essential services. Indirect exposure could be via customers or vendors with exposure to a troubled bank.”
As financial services are so intertwined into everything, everywhere, it is difficult to map out weak points in the banking system. Too frequently, the experts reflect on rearview mirror issues while missing the big picture right in front of you.
The second issue is more obvious. Banks are worried, and they will naturally reduce risk, which means access to capital will diminish. Combine this with the US Federal Reserve’s aggressive rate-tightening freight train, and clearly, growth is slowing – probably far faster than anyone knows.
“In this environment, as the recent bank failures exemplify, there is a potential for shocks arising from interest rate risk, asset-liability mismatches, high asset or liability concentration, poor governance, low profitability, higher leverage and vulnerable business models. Banks are not the only type of entities with exposure to such shocks.”
And finally, policymakers can get it wrong. The law of unintended consequences can rear its head and blindside everyone. Currently, it is a juggling act, stubborn inflation and financial stability concerns. Throw in elected politicians, who frequently do not understand markets, and their need to be seen doing something and the future seems terrifying.
Moody’s adds:
“With inflation still high and labor market strength continuing in the US and Europe, the failure to rein in inflation now could lead to de-anchoring of inflation expectations and increased nominal bond yields, forcing even more tightening later to restore monetary policy credibility. However, as the recent banking sector developments show, financial stability risks could materialize in unexpected places as policymakers seek to steer the economy toward a lower inflation path. The dilemma for monetary authorities is that interest rate increases to address inflation could spur financial stability risks, while measures to preserve financial stability, such as enhanced liquidity facilities, would undercut the objective of tamping down inflation through tighter financial conditions. Meanwhile, uncertainty around policy itself could tighten conditions in unexpected ways, accompanied by volatility. This, in turn, could steepen the economic downturn, raising unemployment significantly.”
The combination of the three potential pitfalls itemized by Moody’s is pretty terrifying. The last one may be the scariest of all. All you need to do is to look at today’s headlines discussing Deutsche Bank as its shares tumble.
The Moody’s banking report is available here.
