Is the bank turmoil in USA over?

The past couple of months have been chaotic in the financial world, especially within the banking system in the USA. In March 2023, Silicon Valley Bank experienced a significant collapse, marking it as the second-largest bank failure in US history and raising concerns about a potential domino effect. Following suit in April 2023, First Republic Bank also struggled to meet the demands of customers requesting withdrawals. By early May 2023, after multiple attempts to find a buyer, First Republic Bank was ultimately sold to J.P. Morgan Chase Bank. This sale highlighted that the banking crisis primarily affected smaller banks with risky long-term investments. However, the question remains: has the turmoil in the banking sector come to an end? And what is more important: can this bank turmoil tank the economy?

Before delving into the aforementioned questions, it is crucial to consider some significant points. Over the past few months, we have witnessed a surge in inflation rates, which has caused financial hardships for individuals. In an effort to curb this worrisome inflation, the U.S. Federal Reserve has been steadily increasing interest rates, reaching a level as high as 5 per cent (the highest since 2007). Furthermore, the Federal Reserve has indicated that while they do not anticipate further substantial increases in interest rates, they may persist at elevated levels for an extended period until they decide to initiate a decrease. This factor holds the potential to shape the future of the banking system and the overall economy, as interest rates play a crucial role in a country's economic landscape.

Currently, two possible scenarios emerge from the situation. In the first scenario, if the banking turmoil subsides quickly, lending and financing standards may normalise, mitigating the economic repercussions. On the other hand, if the upheaval persists or extends to other sectors of the financial markets and the economy, the consequences could be substantial. Challenges in acquiring loans or issuing debt would hinder business growth and employment, potentially triggering a recession.

Amidst the banking turmoil, the riskiest companies are encountering difficulties in accessing debt markets, whereas relatively healthier corporate borrowers have been able to issue bonds, albeit at increased costs. Observers are closely watching how the banking upheaval affects commercial real estate, which is already grappling with pandemic-induced office vacancies and a reliance on smaller banks for loans. Consequently, due to the elevated interest rates, tighter credit conditions are anticipated for households and businesses. However, the complete extent of these effects and the appropriate response remain uncertain.

The prevailing belief in a smooth economic transition, as conveyed by Jerome Powell and the Federal Reserve, has significantly diminished. Prior to the recent banking upheavals, global GDP was steadily growing at an annual rate of 3 per cent, and employment prospects were improving in developed nations. However, following these banking collapses, two major concerns have emerged: uncertainty and credit availability. Regarding uncertainty, individuals may curtail their consumption and investment if they fear the ramifications of a banking crisis and the resulting economic hardships. As for credit availability, financial institutions, wary of potential losses, may reduce lending, thereby depriving businesses of vital capital. Fortunately, there are indications that the recent turmoil may not have as profound an impact as anticipated.

History has shown that when banks are in danger of failure, the stock market usually reacts in a negative way. The memories of the Dow Jones plummeting by 6 per cent in the wake of Continental Illinois' rescue in 1984 and the 10 per cent slide following Lehman Brothers' collapse in 2008 still linger. The Great Depression witnessed an even more devastating impact, with the stock market shedding a staggering 89 per cent between September 1929 and July 1932. However, in a surprising turn of events, the present situation has unfolded in an unprecedented manner. Despite the unsettling backdrop of three American bank failures and the exodus of deposits from small institutions, optimism prevailed. March witnessed the S&P 500 index, the stalwart of American stocks, celebrating a remarkable 4 per cent  gain-a substantial return that surpassed the long-term monthly average of around 0.5 per cent. This jubilation was not limited to American shores alone, as European stocks enthusiastically rallied by 3 per cent, painting a broader picture of market exuberance in the face of adversity.

Despite the surface optimism displayed by the market following recent bank failures, a closer look reveals lingering doubts among investors. While regulatory interventions may have injected temporary confidence, the intricate dance of interest-rate markets and diverse stock types suggests a preoccupation with potential rate cuts rather than an overall assessment of economic wellbeing. Notably, the resilience of tech giants like Apple and Microsoft, impervious to the impact of higher rates, has offset the decline in bank and financial-share prices, creating a semblance of market gains. However, individual investors have assumed a more cautious stance, opting to reduce their stock purchases after an initial surge. Moreover, the growing demand for interest-rate derivatives designed to safeguard against catastrophic scenarios hints at an undercurrent of unease and a prudent readiness to brace for potential downturns. While headline share prices may paint a rosy picture, the actions of investors unveil a delicate balancing act between hope for the best and prudent preparation for the worst.

A proof that the bank turmoil is not over yet is that bank's stocks keep tumbling still, with the last case being PacWest Bankcorp. PacWest Bancorp faced a notable downturn in its stock value as its deposits experienced a sharp decline of 9.5 per cent within a single week. The primary cause of this decrease can be attributed to news reports disclosing the bank's exploration of various options and ongoing discussions with potential investors and partners. PacWest Bancorp confirmed its active evaluation of all available alternatives. To accommodate the withdrawals, the bank utilised its on-balance sheet liquidity. The headlines regarding these developments heightened customers' concerns regarding the security of their deposits, leading to the outflow of funds. Despite possessing adequate liquidity to cover uninsured deposits, the stock market responded unfavourably, with PacWest Bancorp's stock plunging by approximately 19 per cent. Furthermore, this downturn in investor sentiment also impacted other regional banks, including Western Alliance, Comerica, Bank of Hawaii, and Zions Bancorp, all of which experienced declining stock values. The SPDR S&P Regional Banking ETF also recorded a 2.3 per cent decrease.

Prominent voices in the financial industry have recently raised alarm bells regarding the stability of the financial sector. Bill Ackman, a billionaire investor, criticised the Federal Deposit Insurance Corporation (FDIC) for its failure to update and expand its insurance regime, attributing it to the occurrence of unnecessary bank failures. He urgently called for the implementation of a comprehensive deposit guarantee regime. Jeffrey Gundlach, CEO of DoubleLine, expressed his prediction that deposits in regional banks will continue to decline unless the Federal Reserve intervenes by cutting interest rates. Mohamed El-Erian, the chief economic adviser at Allianz, expressed scepticism about the Federal Reserve's communication and its claim that the worst of the banking turmoil is over, cautioning that such assertions could undermine the credibility of the Fed. Paul McCulley, the former chief economist of PIMCO, emphasised the transition from the acute phase to the chronic phase of the banking crisis, as banks are anticipated to curtail lending, tighten credit conditions, and further impede economic growth.

There are three compelling reasons why we believe the banking nightmare is far from over. Firstly, the ongoing weakness exhibited by banks is concerning. It's unsettling that news about mid-sized banks facing collapse or experiencing plummeting stock prices is not uncommon. This instills fear in people, prompting them to withdraw their funds and seek safer alternatives. As long as this trend persists, the risk of a complete banking system collapse remains a viable threat.

Secondly, the absence of a stock market crash is noteworthy. Historical patterns have demonstrated that market crashes often precede banking failures, and there is no compelling reason to believe that this time will be an exception. While it is not an inevitable occurrence, a market crash would serve as a significant indicator that the end is drawing near.

Lastly, there have been no substantial macroeconomic changes. High interest rates persist, and challenges related to inflation and employment persist unabated. Adding to these concerns is the impending issue of the U.S. debt ceiling, which necessitates an increase in the coming month to avoid default. Failure to address this matter would have unprecedented consequences. To confidently assert that the banking turmoil has subsided, a game-changing event must transpire, but only time will reveal what lies ahead.

Kabir Hassan is a Professor of Finance at the University of New Orleans, USA. [email protected].

José Antonio Pérez Amuedo is a Ph.D. Student at the University of New Orleans, USA