Premium: Mohamed El-Erian – What happens in the banking sector won’t stay there

By Mohamed A. El-Erian*.The sudden loss of confidence by depositors in some US banks is causing many to focus on the scope for financial contagion and the needed policy responses. What should not be overlooked is the other, and slower, contagion channel in play — that involving enablers of economic growth — which is less in focus but also important in determining how quickly the world's largest economy will overcome this abrupt air pocket..Banking is based fundamentally on trust. Any erosion in trust can, and does, lead to outcomes that were deemed highly unlikely or even unthinkable just a few days earlier..___STEADY_PAYWALL___.This has played out recently with the sudden collapse of Silicon Valley Bank, the forced sale of Credit Suisse to UBS and the instability at First Republic Bank. Reacting to the news, US depositors have reallocated part of their funds away from smaller banks and into the largest banks deemed too big to fail, money market funds and even crypto assets such as Bitcoin..Read more: Peche's money manager brain proposes solutions to two crises – European Banking and SA's Rainbow Coalition.The magnitude of these deposit flows is far from insignificant, a development that will become even more apparent when the (lagged) data is released on Friday. So far, numbers from the Federal Reserve show that small banks lost $120 billion of their deposits in the week ended March 15, or a 2% decline from the previous week, on a seasonally adjusted basis. By contrast, deposits at large banks increased $67 billion..The loss of deposits reflect a simultaneous convergence of four factors: long-standing structural weaknesses in the most fragile banks; Fed supervisory lapses; an interest-rate hiking cycle that started late and was far too slow, forcing one of the most concentrated set of rate increases in history; and the simple upside/downside calculus that, in the context of shaken confidence, favors deposit transfers even when the risk is objectively deemed low..Some have seen the impact on financial intermediation as insignificant because much of the deposits have remained in the banking system. Yet even if that is the case, it fails to capture the offsetting items on banks' balance sheets. Specifically, the banks receiving the deposits are likely to have different propensities to lend, thereby influencing the scale and distribution of overall lending..Read more: The fragile foundation of banking: Trust, confidence, contagion and systemic risk.This could become a big issue for local communities, regions and sectors that fear that their access to loans will be curtailed because their traditional banking partners will have to shrink their balance sheets after losing deposits. It is also an issue for policymakers..Working together, the Fed, Federal Deposit Insurance Corp. and Treasury can calm systemic deposit fears by liberally using refinancing windows and signaling a willingness to repeatedly trigger the systemic risk exemption to guarantee all deposits, as they did at SVB – that is, the use in exceptional cases of the lowest-cost intervention to counter serious economic spillovers and financial instability. But that is unlikely to immediately and fully reverse the flow of fleeing deposits, thereby increasing the risk of a credit contraction that could undermine overall economic activity..Unfortunately, there are no easy and immediate policy measures to offset this new headwind to economic growth, especially given the nature of the potential credit contractions and partisan realities in Washington. Moreover, the reduction in lending was not supposed to happen so early, if at all, for small- and medium-size companies that have not overborrowed given the change in refinancing conditions (as is the case, for example, in the highly leveraged segments of commercial real estate)..Read more: A new chapter of Capitalism emerges from the banking crisis.This economic contagion, which will play out over time, threatens to increase the challenges facing an economy that is dealing with inflation, a mishandled interest-rate hiking cycle, declines in personal savings, bouts of financial instability and a slowing global economy. It also complicates the longer-term adjustments needed for the green energy transition, the rewiring of supply chains, changing globalization, and the management of debt traps..What is happening now is a reminder to financial companies, regulators and supervisors that the effects of banking accidents are unlikely to be contained to the banking sector. It is also a reminder to markets not to allow the understandable focus on supersonic-speed financial contagion divert all the attention away from slower-moving economic contagion..*Mohamed Aly El-Erian is an Egyptian-American economist and businessman. He is President of Queens' College, Cambridge, and chief economic adviser at Allianz, the corporate parent of PIMCO where he was CEO and co-chief investment officer..© 2023 Bloomberg L.P.

Premium: Mohamed El-Erian – What happens in the banking sector won’t stay there

Related Stories