Swe-Cham Member Handelsbanken shares their insights on the current Economic situation.
“I am the wisest man alive, for I know one thing, and that is that I know nothing”. This quotation derives from Plato’s description of the Greek philosopher Socrates. If this was Socrates’ view, one would imagine that he would have been well equipped to cope in the current financial markets. Conviction can often be a good quality to have, but at present it’s more important to be open to new events and movements in the market. Events surrounding the relatively small bank SVB do not seem typical of other banks in any way – in any case not in Europe, and particularly not in Sweden. But they highlight the fact that the rapid tightening of global monetary policy is not without its consequences, and give central banks another cause for concern. We can no longer take further tightening measures for granted, despite the fact that a protracted period of high inflation seems likely. After it was decided that UBS buys Credit Suisse, new questions arise about some of the banks market financing.
Fear itself is a reason for fear
Since I’ve already dug up one common quotation, here’s another: “The only thing we have to fear is… fear itself”. President Roosevelt’s inaugural address from 1933.
For isn’t it true that the problems surrounding SVB are in many respects limited to a few, relatively small, US banks? Thus the slide that we saw in yields and for expectations of central bank key rate hikes may have been blown out of proportion somewhat. But what many of us are thinking, which may mean that yields do not return to their previous levels in the near future and central banks may need to reconsider their rate hikes and divestment of bonds, is that the tightening measures have taken place very rapidly. Following a lengthy period of extremely expansionary monetary policy in historical terms, there may well be other potential hazards around the corner that we won’t discover until it’s too late.
One of the oft-quoted comments about the US Federal Reserve’s approach has been that they will keep hiking rates until something breaks, and in that respect, they may now have reached that point. In our view, it’s still likely that there are more hikes to come, but we don’t know what will break next time. It seems like the fallout from Credit Suisse’s difficulties will be the next misfortune.
Do credit channels drying up make hikes superfluous?
It is important to point out that our main scenario is still one in which central banks will be compelled to continue with rate hikes in order to tackle inflation. This applies in particular to the Swedish Riksbank, following the exceptionally high inflation figures announced on Wednesday, which came as a major surprise.
There are reasons to believe that the Riksbank might be able to “afford” higher rate hikes than central banks in the eurozone is that, despite all the negative press surrounding the Swedish property market, Swedish banks seem to have a scope for new lending. Firstly, Swedish authorities, true to form, have been much stricter with regard to capital adequacy and liquidity requirements. Moreover, banks in the eurozone have for many years been restricted by low valuations. If we consider the banks included in the Euro Stoxx Bank Index (hardly scraping the bottom of the barrel in other words) they are, on average, valued at levels far below their shareholders’ equity. Currently at around 66 per cent. A bank with such a low valuation will be expected to lose money on its credits, and granting further credit, all else being equal, will only drive its valuation down further. More lending – more credit losses. The correlation between the granting of credit and the market’s valuation of banks goes back many years. However, the correlation didn’t apply during the pandemic, because the ECB introduced a number of incentives to encourage new lending that the banks simply couldn’t say no to. If banks increased their lending, they were given access to more funding from the ECB, at cheaper rates. In some cases, guaranteed by the government as well.
An unweighted average for the valuation of the four major Swedish banks’ equity, including Nordea, is 106 per cent.
Even before recent events, a more restrictive approach was being taken for the granting of credit. Now, banks need to be even more cautious as the sentiment around them are souring and more banks risk being scrutinized.
The vicious circle of higher rates – stricter credit conditions – credit losses – bank problems – stricter credit conditions – credit losses – bank…
It is important to remember that we still are a far way from a new banking crisis, but the risks of one does not come from the classic bank run scenario where loss of liquidity makes a bank go bust, even if that is part of the truth with the American bank SVB. Banks in the in eurozone will always get more cash from the ECB. Otherwise, there would be no Greek banks left. In order to bring a euro area bank to its knees they need to loose equity, most probably from credit losses.
So the danger for banks today are the after many years of extremely loos monetary policy, interest rates are up and money supply decreasing (through the shrinking of central banks balance sheets). Many borrowers are struggling with higher interests and on top of that, banks are getting more restrictive with credits. Maybe some are unable to loan at all. This in turn means companies go bankrupt and are unable to make good on loans they already have. Credit losses start adding up with banks and the losses see their equity shrink and they need more capital.
It is important to stress that we are not there yet and probably not very close. But exactly how far away we are from a new financial crisis is the question everybody is asking right now.
The author is Lars Henriksson, Handelsbanken Economic Research Sweden.