Risks in the US Banking System: Potential Impacts and Contagion Concerns

US banking troubles flare up again

Our base case: The European banking system has coped well with the bank worries at the beginning of the year. The positive impact from higher interest rates continues to support European banks, with the negative side effects still contained. The solid liquidity positions of banks have been confirmed by the very limited additional drawings from the ECB’s regular funding operations, despite the substantial TLTRO-III maturities that took place at the end of June. The European bank debt markets have also shown some promising signs with some action on the AT1 debt markets in mid-June, despite the full write-down of Credit Suisse's AT1 capital earlier this year.

Concerns over the US banking system have eased in the course of the second quarter. The issues have not spread to larger US banks, we have not seen further severe liquidity stresses and deposit flows have broadly stabilised.

The Fed published its bank stress test results in late June, which confirmed that the larger US banks could weather substantial weakness with their existing capital buffers. The Fed modelled a severe recession including US$541bn in forecast losses to result in a 230bp decline in the average CET1 ratio of the 23 banks. Large banks retained relatively solid modelled CET1 ratios. Banks with the lowest (and highest) stressed CET1 capital ratios were smaller or mid-sized banks. This group could be somewhat less well-positioned to weather weakness with their existing CET1 buffers.

 

Risk scenario and how it plays out: 

The US bank problems were driven by a quick loss of confidence on the part of uninsured depositors towards regional banks. If the loss of confidence were to spread quickly to impact more institutions, it could result in several banks struggling to absorb deposit outflows simultaneously. This could create worries over contagion in the system and exaggerate further deposit instability. Finding buyers for assets to safeguard depositors and operational continuity for several, although smaller, banks at the same time could pose challenges.

In the very worst-case scenario, several smaller lenders end up being absorbed by larger ones. The failing banks may, however, come with unforeseen additional risks, which may eventually result in the credit profiles of the larger acquirers weakening more than expected. If the issues are severe enough, they may pose risks to the stability of the larger acquiring banks. If investors start second-guessing the stability of the financial system, this may have severe consequences on financial markets.

 

Wider economic impact: 

Fresh banking stresses would fuel a further tightening in lending standards than we’ve already seen in the US. History shows this is almost always followed by a sharp rise in the unemployment rate and would deepen the recession we already expect. While it’s uncertain whether contagion would spread directly to Europe, the prospect of a US downturn would inevitably have wider economic repercussions overseas. Central banks have so far been able to separate out financial stability and monetary policy tools, but such stresses, should they happen, are ultimately borne out of higher interest rates. This scenario would likely herald earlier and more aggressive rate cuts in both the US and Europe.