Testing the Separation Principle

• We think the drastic downward revision in central banks’ terminal rate is overdone
• The current banking turmoil could trigger a steep deterioration in activity, but at this stage, some circuit breakers can still help.

Markets reacted to the continuation of the banking turmoil last week by drastically revising down their expectations for the Fed and the ECB’s policy rate, expressing their scepticism at the possibility that central banks could respond to the financial stability issues with liquidity measures alone, without altering their policy stance. While we agree that more prudence is warranted in the pace of tightening – we think that in the case of the ECB resorting to 25 bps hikes rather than the recent increments of 50 bps should be way forward - central banks are likely to balance the already tangible signals that inflation is taking too much time to decelerate with the mere possibility that the banking stress triggers a steep deterioration in economic activity and hence dampens inflationary pressure.

We don’t want to downplay the importance of what’s going on. In the US, deposit migration from smaller to larger banks would not be neutral from a macroeconomic point of view. Small banks exhibit in general a much higher loan to deposit ratio than their larger competitors, and they play a crucial role in a sector – real estate – which is already under significant pressure. Higher banks’ funding costs – if the risk premium drifts higher – would be another transmission channel (we find a quite tight correlation between banks’ refinancing gaps and their lending standards to firms). Yet, some circuit-breakers exist. In aggregate terms, small banks in the US have comparatively less interest-rate sensitive securities on their balance sheet than their larger counterparts (this was a specific issue for SVB). The solution for Credit Suisse found with UBS (and the decisive support from the Swiss government and central bank) implies a write-down of the AT1s, but bonds higher up the seniority ladder seem to be protected. 

Confidence always plays a major role in banking crises. In the 1980s, it took years to finally deal with the Savings and Loans saga (which bears some resemblance with the current US predicament). This time, public authorities are clearly intent on acting big and fast.