News in Charts: Banks’ risky business

JP Morgan last week tabled the most attractive bid to take over the deposits and most of the assets of troubled US regional bank First Republic. However, it is likely that bondholders and shareholders in the lender have been wiped out. The regulators who negotiated the deal appear to have been balancing the need to maintain financial stability with avoiding blanket cover to investors that might fuel perverse incentives.

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The current US banking stress is a timely reminder for investors and the wider public about the flakiness of bank deposits and the risks in the banking sector. In this regard banks can be thought of as being exposed to two main sources of risk: duration risk (or interest-rate risk) and credit risk. Duration risk stems from the maturity profile of the balance sheets. Banks’ assets tend to fall due later than their liabilities, since deposits, for instance, are redeemable immediately while a loan or a mortgage will have a longer maturity, often a few years ahead. This maturity mismatch makes a bank sensitive to interest-rate changes and an inverted yield curve, and has been the main culprit behind the demise of Silicon Valley Bank (SVB), Signature and First Republic.

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The second source of risk – credit risk – has so far been less discussed. We believe it merits a closer scrutiny, however, as interest-rate risk has a habit of cascading into credit risk through the banking sector. For instance, in their search for higher yields many depositors are moving their money from US banks to money market funds. As banks lose deposits, their capacity to lend or renew existing loans is constrained. This means that borrowers must pay more for credit or may not get credit at all. This can create negative feedback loops for the real economy, as less credit means less spending, investment, and growth.

These effects are already happening. The next chart shows that there is a short lag between banks tightening their credit standards and small businesses noticing a lower availability and higher cost of credit. The latest data from America’s National Federation of Independent Business (NFIB) show that more firms are reporting a tougher credit environment since February.

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The lags between tighter credit standards spilling over from banks into the broader economy are somewhat longer, as the next chart suggests. It takes about a year for unemployment to peak after credit tightness is at its highest, as measured by the share of banks charging higher interest rates in excess of their cost of funding.

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A higher level of bankruptcies is one key mechanism through which tighter credit standards from banks spill over into higher unemployment. There are clear signs that this dynamic has already taken hold. Insolvencies appear to have bottomed in the US and have already started to rise in Europe and the UK.

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Moreover, decades of zero or negative interest rates coupled with generous pandemic support programmes have created large swathes of corporate zombies which could pose a severe risk to the global economy in the current cycle. Everyone’s attention is rightly focused on US banks, but the role of banks in the unfolding credit cycle should warrant an even closer inspection.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

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