Financial authorities in U.S., Europe warn about potential credit crunch

Financial authorities in the U.S. and Europe have cautioned the market on the potential credit crunch triggered by the recent banking turmoil.

Minneapolis Fed President Neel Kashkari said it was "unclear" if the banking stress would lead to a "widespread credit crunch." He noted that a credit crunch would significantly slow down the U.S. economy, but he also said that officials are monitoring the situation "very, very closely."

Kashkari, a proponent of a higher interest rate to bring down inflation, said the turmoil in the banking sector had brought the Federal Reserve closer to the peak interest rate. The 25-basis-point rate hike implemented last week brought the current benchmark rate to the 4.75 to 5.00 range.

Meanwhile, the European Central Bank (ECB) has warned that the recent turmoil in the banking sector may lead to an additional tightening in lending. ECB vice president Luis de Guindos said it would lead to lower growth and inflation.

In the U.S., the banking crisis began when California-based regional lender Silicon Valley Bank (SVB) was suddenly shut down on March 10 following a liquidity crisis. Later that week, financial authorities closed another regional lender, the New York-based Signature Bank, to manage "systemic risks" in the banking sector.

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The market's confidence in the banking sector went down, as shown by plummeting bank shares in the week following the implosion of SVB and Signature. As a result, backed by the Treasury Department, the Fed established a new lending facility to enhance bank liquidity and restore stability in the financial market.

However, Credit Suisse in Switzerland announced a liquidity crisis not long after. The Swiss National Bank attempted to save Credit Suisse by providing a $54 billion loan to resolve the situation but later engineered a buyout for the troubled lender. UBS agreed to acquire its rival bank at a much lower rate than the original market price.

First Republic Bank, a San Francisco-based regional lender, was under scrutiny over the past two weeks due to a liquidity crisis. It had received a loan from larger banks to tackle the issue but later raised concerns that it would need to raise more capital. Recent news suggested that the Fed was considering expanding its emergency lending program to save First Republic and some other struggling lenders.

Meanwhile, shares of the German Deutsche Bank were down 8.5 percent last week after reporting a sudden spike in its default insurance. However, German authorities have assured the public that Deutsche was still in a sound state, advising against making baseless speculations about the bank's future.

Financial markets were volatile last week as a result of the banking turmoil. The euro fell against the greenback. Meanwhile, government bond yields in the U.S. and the eurozone sank, indicating that yield prices increased as investors moved their funds to the safer instrument.

Reports also said that other than Deutsche, other European banks are also experiencing the rising cost of insuring against defaults, while data from the U.S. revealed an increase in the number of depositors moving their money from smaller to larger banks even though Fed chairman Jerome Powell said last week that the banking situation had "stabilized."

Concerns regarding central bank policies

The recent banking turmoil has raised concerns about whether central banks will continue to pursue aggressive interest rate hikes in the coming future.

Last week, the Fed raised interest rates by 25 basis points and signaled a possible pause soon. Its European peers also hiked their interest rates, the Banks of England (BoE) with a 25-basis-point hike and the SNB with 50 basis points. Norwegian banking authorities also increased its benchmark rate by 25 basis points.

Switzerland and Norway already announced that they would continue increasing interest rates, while the BoE said it would monitor the situation before deciding the next course of action. Further monetary tightening may lead to a greater financial crisis, as noted by analysts.

England's UniCredit Global chief economist Erik Nielsen said central banks should not separate monetary policy from financial stability, especially with the crisis of confidence in the banking sector.

High interest rates, as a result of monetary tightening by central banks, are partially responsible for causing the banking crisis. High rates lead to higher borrowing costs for businesses and households, resulting in drops in new loans which hurts bank profits. Additionally, it encourages banking consumers to pull out funds from their savings, which can cause a liquidity crisis.