Repercussions of banking stress on the Asia-Pacific region

Christy Tan April 12, 2023 10:37

In the week since the Silicon Valley Bank (SVB) bankruptcy, global authorities have stepped in starting with the Federal Deposit Insurance Corporation (FDIC), the Swiss National Bank (SNB), the People’s Bank of China (PBoC), and the US Federal Reserve (Fed), offering lifelines of liquidity. This will temporarily provide a lid on funding costs so that assets can be unwound with lesser damage to the banking sector balance sheets and loan books can be extended.

The United States is focused on ringfencing liquidity and funding issues, while Asia is throwing support to its banks.

US-dollar funding is increasingly a global concern and restoring investor confidence may require a global effort. US banks are showing signs of liquidity strains that prompted a record US$164.8 billion in emergency borrowing from the Fed’s discount window. The “dash for cash” also appeared in the Federal Home Loan Banks (FHLBs) system as well as significant rise in repo agreements and forward rate agreements. A “flight to safety” saw bank deposits being withdrawn and rotated into money market funds. FHLBs raised almost US$90 billion in floating-rate notes, on top of other significant funding of about US$260 billion through term discount notes and overnight instruments.

In Asia, the PBoC unexpectedly cut the reserve requirement ratio (RRR) by 0.25%, barely a week after the SVB collapse and Credit Suisse troubles. Policy tightening may be put on the backburner for now, and some central banks in Asia may start to ease monetary policy earlier than initially planned.

Asian regulators must hold the bottom line of financial stability

The SVB turmoil was a by-product of the Fed’s aggressive rate hikes. Inflationary pressures in Asia may be relatively contained. However, the onus to bring monetary policy from a tight to a neutral state and hold it there for as long as possible is more pertinent than ever.

A deeper look at the US-dollar funding landscape in Asia

Asian central banks will have to manage currency volatility, as bouts of US dollar strength in the near term could lead to further dislocations because of a reduction in the repayment capacity of unhedged borrowers outside the United States. This may further limit their access to the US dollar, increasing the demand for synthetic US-dollar funding, and escalating risk aversion. Funding risks in US dollars or other foreign currencies warrant special attention as central banks cannot create foreign currencies, and the currency regime or the size of their foreign reserves may constrain their ability to meet banks’ demand for US dollars.

There are more US-dollar liabilities outside the United States than within the country itself. The middle- and low-income countries saw external debt (mostly in US dollars) rise from US$6.39 trillion in 2015 to US$9.3 trillion in 2021. The complex link between Asia’s borrowers and creditors, with banks as intermediaries, could trigger portfolio outflows when the flow of funds is interrupted.

The flow of investment to non-US economies involves a chain of transactions that passes from ultimate savers to non-bank financial institutions (NBFIs) and banks, then other intermediaries, before the ultimate non-US borrowers receive the funds. These intermediation chains are now long and complex, across borders and different markets. The intermediation chain is only as resilient as its most vulnerable link.

The greater role of debt markets and NBFIs in funding emerging markets and Asia, along with the chains of intermediation involved in supplying this funding, has made US-dollar liquidity more central as a shock absorber. The chain of events in recent years—including the COVID-19 pandemic, the Russia-Ukraine war, and now US-banking sector stresses—has resulted in shifts in both the demand and supply of liquidity. The demand for liquidity has grown as the size of debt markets and the importance of investment funds offering liquidity-on-demand has increased. The problem is, the supply of market liquidity from banks alone, will not be able to keep pace with this increase. New providers of liquidity may fill some gap, but they have not been stress tested sufficiently.

Strength in Asian banking sector and opportunities in Asian fixed income

Asian central banks may be more inclined to implement accommodative and growth supportive policies to cushion the liquidity stresses, creating a more constructive environment for Asian fixed income. Most banks in Asia have been maintaining strong capital buffers and managing prudent leverage post-Russia-Ukraine war and as the Fed embarked on a monetary policy tightening path. Furthermore, the monetary easing moves during the COVID-19 pandemic allowed lenders to strengthen their capital buffers and reduce risk exposures. Banks in the Asia-Pacific region (APAC) are well capitalized and most large APAC banks posted year-over-year improvements in their Basel III leverage ratios in the second quarter of 2022, with mainland Chinese banks leading the pack.

Japanese banks’ exposure to US Treasuries may be sizable but manageable

Concerns over Japanese financial institutions’ exposure to long-term foreign bonds in a rising-rate environment may be misplaced. Japanese banks and financial institutions differentiate themselves with ample capital and liquidity as well as diverse funding profiles without outsized concentration in a single industry or segment. Furthermore, Japanese officials from Bank of Japan (BoJ), Ministry of Finance (MoF) and its financial watchdog affirmed a coordinated front in readiness to respond to any shocks.

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Christy Tan

Investment Strategist, Franklin Templeton Institute