One of the few crumbs of comfort amid the turmoil in financial markets over recent days is that the global banking system does not appear to be in imminent danger. This reduces the risk that a severe global downturn morphs into a full-blown financial crisis and economic depression. If problems do emerge over the coming months, Italy’s banks appear to be the weakest link in the global chain.
- One of the few crumbs of comfort amid the turmoil in financial markets over recent days is that the global banking system does not appear to be in imminent danger. This reduces the risk that a severe global downturn morphs into a full-blown financial crisis and economic depression. If problems do emerge over the coming months, Italy’s banks appear to be the weakest link in the global chain.
- Banks sit at the heart of market economies – intermediating between savers and borrowers and ensuring the smooth flow of credit to households and businesses. One consequence is that when the banking sector collapses, the real economy tends to follow suit. History shows that the deepest recessions tend to have their roots in banking crises.
- Banks can get into trouble in two ways. The first is due to problems on the asset side of their balance sheets. These can have different origins, but often follow a similar pattern: a period of rapid credit growth leads to a misallocation of capital and/or inflates bubbles, which then burst, causing a sharp rise in loan defaults that threaten banks’ solvency.
- The second source of trouble comes from problems on the liabilities side of banks’ balance sheets. The classic crisis stems from a “run on the banks” – deposit flight, usually triggered by concerns about deteriorating asset quality and future solvency. But the global financial crisis underlined another source of vulnerability. A growing dependence on wholesale funding (as distinct from deposit funding) left banks vulnerable to the freeze in money markets caused by a collapse in counterparty confidence.
- So where do banks stand today? In theory, they now hold more capital and so are better able to withstand a sudden deterioration in asset quality. But bank capital ratios were not unusually low on the eve of the 2008 financial crisis – the problem instead lay with the dubious quality of banks’ capital. A better approach is to look for other warning lights: rapid lending growth, falling lending standards and the emergence of asset price bubbles or macroeconomic imbalances. Property is often at the root of these problems.
- The economic downturn caused by the coronavirus shock will affect the ability of borrowers to repay loans. Some banks have already announced plans to allow a moratorium on repayments by borrowers that experience virus-related disruption. If these become widespread, governments may need to provide support to affected banks.
- But the warning lights that have tended to signal more fundamental problems lie in store for the banking sector are not yet flashing red. Credit growth in major developed economies has been relatively subdued. (See Chart 1.) Housing markets in Canada, Australia and Sweden look overvalued, but otherwise there is little evidence of property bubbles. (See Chart 2.) And the pockets of excess we have identified in the corporate debt market are more likely to cause losses for bond holders than banks.
- Meanwhile, on the liabilities side of the balance sheet, there is so far little evidence of significant strains in money and credit markets. (See Chart 3.) And loan-to-deposit ratios in developed economies have fallen from the levels seen before the financial crisis. (See Chart 4.) This leaves banks less vulnerable to a freeze in global credit markets.
- Stepping back, there are currently two major weak links in the global banking system. The first lies in the exposure of China’s banks to an over-leveraged property sector. But the unique characteristics of China’s financial system mean that this is likely to play out in a different way to previous lending binges. We expect that Beijing will step in to prevent widespread defaults – and the economic disruption caused by the virus makes any such intervention more likely rather than less likely.
- The second vulnerability lies in the euro-zone and, in particular, Italy. The slump in Italy’s economy that’s likely to result from measures imposed to contain the virus will impair the ability of households and businesses to repay loans. It’s possible that some form of government support may be required. (For more, see our forthcoming note on the Europe service.)
- But an added weakness is that banks in the euro-zone hold large amounts of their governments’ debt. This raises the prospect of a self-reinforcing “doom loop” in which concerns about fiscal sustainability in the wake of the coronavirus shock cause a deterioration in banks’ asset quality, which in turn exacerbates concerns about the government’s finances. As things stand, this remains a significant downside risk rather than a central scenario. But if banking sector problems do emerge over the next month or so, Italy is likely to be the place to look.
- So where does this leave us? The key point for now is that the global banking system as a whole looks relatively well placed to weather the economic disruption and subsequent market dislocation caused by the coronavirus. It may be cold comfort, but that should prevent a severe economic downturn from morphing into a full-scale depression. If banking troubles do materialise, Italy looks like the weakest link in the global chain.
Chart 1: Change in Bank Lending to the Private Sector as Share of GDP (%-pts)
Chart 2: House Price-to-Income Ratios
Chart 3: 3M LIBOR-T-Bill Spread & EUR/USD Basis (bp)
Chart 4: Loan-to-Deposit Ratios (%)
Sources: Refinitiv, Capital Economics
Neil Shearing, Group Chief Economist, +44 20 7808 4985, email@example.com