When do banking failures matter for the economy?

When I began studying economics around the turn of the millennium, hubris engulfed the profession.

One of the slides displayed during our first macroeconomics lecture was a chart of global GDP since the middle of the 19th century. It showed the global economy expanding exponentially over the entire period — besides one noticeable blip in the early 1930s.

That blip, sparked by the Wall Street crash of 1929, was, according to the lecturer, to all intents and purposes, irrelevant. “Don’t worry,” we were told, “we have solved that, it won’t happen again.”

Policymakers are no longer quite so cocky.

The global financial crisis in 2008 put paid to notions that all the questions on how to keep economies purring along nicely had been answered. It also opened up the eyes of many to the now blindingly obvious notion that the health of banks matters for the rest of us.

What caught out almost everyone before the collapse of Lehman Brothers was a view that the financial system was little more than a conduit for economic activity, an efficient allocator of capital devoid of its own inner life.

But do we now risk reading too much into finance’s capacity to create havoc?

The failure of Silicon Valley Bank has triggered concerns of a broader financial panic that could, in turn, spark a brutal credit crunch that would throw economies into recession. Those concerns were the reason the US authorities gave for bailing out all of the Californian lender’s depositors.

Yet, its business model — and the risks it took — are somewhat unique.

And there are many instances, such as the bursting of the dotcom bubble, when panic in financial markets has not had too devastating an impact on growth.

So how do we tell when banking failures will, and won’t matter, for the economy?

Often only with hindsight, is the honest answer.

Few would have suspected that, weeks after the collapse of SVB — a bank that few of us had heard of until it crashed — analysts would be blaming it for Saudi Arabia’s decision to cut its oil quota.

As is often the case, the past doesn’t provide us with all the answers, but it offers some guidance.

For the failure of a bank to affect the broader economy, two things have needed to happen. The first is that the failure must lead to a broader financial panic. The second is that the panic needs to trigger a broader credit crunch.

Banking is an unusual industry in that the failure of a rival is not necessarily a matter of cheer for those left standing.

UBS was a reluctant player in the rescue-takeover of Credit Suisse. If it had walked away, however, the consequences would have been likely even worse for it and, one suspects, for the rest of Europe’s banks.

So one of the first signals of concern is the degree to which one bank’s troubles creates negative externalities for its peers.

This can often be a question of perception. Can the failed bank be seen as unique in some respect? Can regulators convince the public others are well-capitalised and well-supervised? Is the broader economic mood confident or gloomy?

One metric to watch is deposit outflows (which is why a lot of people have been keeping a close eye on the US Federal Reserve’s H8 release of late).

In the past, however, the impact could take a while to feed through, even in bouts of turmoil as severe as the Great Depression. Here’s an out-take from a 2000 paper by economic historian Geoffrey Wood:

“Bank deposits rose from January to March 1931, and in 1931 there were some signs that the downturn in activity was approaching an end. Industrial production rose from January to April, and the rate of decline of factory employment slowed sharply. But a second banking crisis broke in March. The public converted deposits to currency, and banks sold assets to increase their liquidity. This action put downward pressure on the money stock, which was only partly offset by inflows from abroad. The Federal Reserve did not act to offset the squeeze.”

In the digital age, a smaller gap between the initial event and the run sounds feasible. But even in the era of 24/7 mobile banking, overall levels of deposits could prove surprisingly sticky.

Recession-inducing panics can also occur without a run. In 2008, for instance, they hardly budged.

A more timely indicator may be corporates’ funding costs, which rose sharply during 2008, as this chart from former Fed chair Ben Bernanke’s Nobel Prize address highlights:

Another factor is what John Maynard Keynes termed “animal spirits”.

Hyman Minsky — an economist who, rather than assume Great Depressions were a thing of the past, asked what circumstances could create another one — placed the impact these animal spirits have on credit conditions at the heart of his work. From Charles Kindleberger’s’ Manias, Panics and Crashes:

“Minsky argued that the growth of bank credit has been very unstable; at times the banks as lenders have become more euphoric and have lent freely and then at other times they have become extremely cautious and let the borrowers ‘swing in the wind’.”

While looking at polls such as this month’s edition of the Fed’s quarterly survey of loan officers will offer some sign of whether banks are indeed about to let their borrowers “swing”, determining whether the global economy is resilient enough to stomach a fresh bout of banking turmoil will take some time.

In the meantime, it’s important for us to be less like economics professors of decades past and more like Minsky, taking nothing for granted.

Other readables

• Nigel Lawson, one of the UK’s most renowned chancellors of the exchequer, died this week. Our obit.

• Investors in the pound are quids in.

• Want to buy a dinosaur? Here’s how.

Numbers news

• The IMF warned this week of the dangers to growth and financial stability posed by “friendshoring”, the phenomenon that describes companies’ and lenders’ increasing reluctance to invest in countries with whom their governments are not on the best of terms. Friendshoring has meant that companies are looking to shift some of their Asian manufacturing out of China to other regional hubs. But, as this excellent graphic highlights, those ambitions might be constrained by a lack of ports infrastructure. (More here.)

Source: Economy - ft.com