Watching Financial Strains

After several small bank failures, pressures have recently emerged in the US financial system.

The stresses have appeared because of significant deposit outflow in recent months as US households accessed funds for revenge spending and sought better returns in credit and equity markets. This deposit outflow was fast and exposed poor liquidity management amongst smaller institutions. Some banks have also been caught out by mark-to-market losses on securities held on balance sheets. The Federal Reserve acted decisively by extending deposit guarantees and offering to buy securities at their par value. This helped contain the damage, but given that there are over 4,000 banks in the US and limited regulation at the smaller end, it would not be a surprise if additional problems emerged.

Stepping back, however, there is much less risk in the financial system than in the lead-up to the 2007 financial crisis. US household debt has declined relative to income, and lending quality has steadily improved. Changes to global capital rules mean that capital buffers are much greater than 15 years ago, particularly for smaller US banks where tier 1 ratios average around 22%. Aggregate levels of liquidity across the US system are also healthy, so even though deposits are leaving, there are still plenty of them overall; the average loan-deposit ratio is only 70% compared with around 100% before the crisis.

This makes a systemic crisis far less likely. However, the Fed will be vigilant and watch for evidence of a credit crunch led by banks’ inability to lend. Some tightening in credit standards is expected during a rising rate period, but a significant change in credit availability would have macro consequences.

Nevertheless, further pockets of stress are inevitable after such a fast and sharp change in interest rates. A few sectors look particularly vulnerable and should be monitored closely. One is US commercial property. Regional banks have been major lenders to real estate, and there could be some pressure points if they cannot refinance loans as they fall due. The office sector, in particular, has seen a jump in vacancies due to the switch to hybrid working. Government debt jumped globally during the COVID crisis and remains exceptionally high relative to history. As rates rise, this debt will be harder to service, and several less-wealthy countries will likely be forced into default.