March’s stress events to tighten financing conditions

Karsten Junius April 26, 2023 10:05

The collapse of SVB and two other (smaller) US banks interrupted the dollar’s downward trend in March. Market-based financial conditions tightened sharply, and the dollar rose substantially in a matter of days. We note that this is consistent with past episodes, suggesting that stress in the banking system can lead to a stronger dollar.

The US dollar tends to strengthen if bank stress reappears

Compared with other G10 currencies, the US dollar usually rises the most against a backdrop of surging market volatility, outpacing the positive sensitivity of the Japanese yen and the Swiss franc, which themselves constitute safe-haven currencies. The unusually high volatility beta of the dollar largely reflects its status as the world’s foremost reserve currency and the associated structural demand for dollar funding, particularly among internationally operating banks and corporates. This means that the US dollar will benefit the most if banking stress resurfaces significantly later this year. Higher bank funding costs and worsening liquidity conditions translate directly into tighter lending standards, and corporate bond spreads tend to widen in line with tighter lending standards. During the Global Financial Crisis, a widening of the 10-year yield spread between A-rated Corporates and US Treasuries by 100bps resulted in a 6% rise in the US dollar. The dollar’s positive sensitivity declined somewhat during the COVID sell-off in March 2020.

Euro area credit growth: Likely to slow further but unlikely to fall off the cliff

Last month’s regional US banking turmoil has had a limited direct impact on banks outside the US. The Fed's swap lines to central banks in major developed economies barely increased (though repo to other (EM) central banks rose by $50 billion in the weeks following the US bank run). Still, credit growth has slowed over the past quarters, reflecting the tighter ECB policy, and concerns remain that it will continue to do so as interest rates have increased. Some banks may face balance sheet problems similar to those faced by SVB in the US, at a time when they have to repay large amounts of long-term refinancing loans (TLTROs) to the ECB. In this section, we would like to add some numbers to the debate.

Estimating credit growth is indeed a tricky thing, as credit demand and supply curves may kink as households may be credit-constrained and banks may be liquidity-constrained. As a result, the observed credit volumes would be the minimum of credit demand and credit supply. Financial markets are typically focused on lending to the private sector, which accounts for nearly 60% of total credit to the economy. The remainder is credit to government, which is largely held by the ECB. It should be clear, however, that there may also be hidden or overt valuation adjustments for commercial banks following last year’s rate increase.

Loans to the private sector amount to €13 trillion. Roughly 40% were home purchase loans to households and another 40% to non-financial companies. Credit to households for consumption purposes plays only a minor role, as do other loans (mainly to non-monetary financial corporations). Credit demand is positively correlated with the business environment, as measured by economic or consumer sentiment, particularly the outlook for the labor market. It is negatively correlated with the level of interest rates, with any change having its greatest impact on a 15-month lag. Given the steep rise in interest rates since last year, it is highly likely that loan demand will slow further in the coming months. However, with a recession likely to have been avoided this winter and business sentiment having recently picked up again, credit growth is unlikely to collapse in the near future.

The same is true for the supply of credit. It benefits from the recovery in economic sentiment and a historically high spread between interest rates on loans and deposits (in contrast to the US, money market funds are not widely developed in the euro area, increasing the stickiness of bank deposits). However, the liquidity position of banks will become less favorable. Until the end 2024, banks will have to repay about €1100 billion of TLTROs, of which €477 billion is due this June. Overall, this should not be a problem for the European banking sector, as it still holds around €4017 billion in excess reserves at the ECB. However, these reserves are not evenly distributed, so we cannot rule out that some banks will have to realize losses on their government debt portfolios in order to repay TLTROs, which in turn would reduce their capital and ability to extend credit to the private sector. Lending standards are therefore likely to be further tightened.

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Karsten Junius

Chief Economist, Head Economic Research at Bank J Safra Sarasin