Banking stress puts U.S. and Europe on watch for credit crunch

© Reuters. FILE PHOTO: Minneapolis Fed President Neel Kashkari speaks during an interview at Reuters in New York February 17, 2016. REUTERS/Brendan McDermid/File Photo

By Howard Schneider and Tom Sims

WASHINGTON/FRANKFURT (Reuters) -Stress in the banking sector is being closely monitored for its potential to trigger a credit crunch, a U.S. Federal Reserve policymaker said on Sunday, as a European Central Bank official also flagged a possible tightening in lending.

Authorities around the world are on high alert for the fallout from recent turmoil at banks following the collapse in the United States of Silicon Valley Bank (SVB) and Signature Bank (NASDAQ:SBNY) and the rescue takeover a week ago of Credit Suisse.

Last week ended with indicators of financial market stress flashing. The euro fell against the dollar, euro zone government bond yields sank and the costs of insuring against bank defaults surged despite assurances from policymakers.

In the latest effort to calm investors, the U.S. Treasury said on Friday that the Financial Stability Oversight Council agreed that the U.S. banking system is "sound and resilient".

"What's unclear for us is how much of these banking stresses are leading to a widespread credit crunch. That credit crunch ... would then slow down the economy. This is something we are monitoring very, very closely," Minneapolis Fed President Neel Kashkari said Sunday on CBS show "Face the Nation."

"It definitely brings us closer," said Kashkari, who has been among the most hawkish Fed policymakers in advocating higher interest rates to fight inflation.

He said it remained too soon to gauge the "imprint" bank stress would have on the economy and therefore too soon to know how it might influence the next interest rate decision of the Federal Open Market Committee (FOMC).

Meanwhile in Europe, the ECB believes that recent banking sector turmoil may result in lower growth and inflation rates, its vice president Luis de Guindos said.

"Our impression is that they will lead to an additional tightening of credit standards in the euro area. And perhaps this will feed through to the economy in terms of lower growth and lower inflation," he told Business Post.

'CONCERNING SIGNS'

After the Swiss government engineered the rescue takeover of Credit Suisse by Zurich-based rival UBS, Germany's Deutsche Bank (ETR:DBKGn) moved into the investor spotlight.

Shares in Germany's largest bank fell 8.5% on Friday and the cost of insuring its bonds against the risk of default jumped sharply and the index of top European bank shares fell.

The sudden spike in tensions for banks has raised questions about whether major central banks will continue to pursue aggressive interest rate hikes to try to bring down inflation, and prompted some to speculate on when rates will start to fall.

Erik Nielsen, group chief economics advisor at UniCredit in London, said central banks should not separate monetary policy from financial stability at a time of heightened fears that banking woes could lead to a widespread financial crisis.

"Major central banks, including the Fed and the ECB, should make a joint statement that any further rate hike is off the table at least until stability has returned to the financial markets," Nielsen said in a note on Sunday.

The Fed raised interest rates a quarter of a point this week but opened the door to pause further increases until it is clear how bank lending practices may change after the recent collapse of SVB and New York-based Signature Bank.

"There are some concerning signs. On the positive side is deposit outflows seem to have slowed down. Some confidence is being restored among smaller and regional banks," Kashkari said.

Turbulence among banking stocks on both sides of the Atlantic continued into the end of the week, despite efforts by politicians, central banks and regulators to dispel concerns.

"We've seen that capital markets have largely been closed for the past two weeks. If those capital markets remain closed because borrowers and lenders remain nervous, then that would tell me, okay, this is probably going to have a bigger impact on the economy," Kashkari said, adding: "So it's too soon to make any forecasts about the next FOMC meeting."

The Fed has rolled out an emergency lending program meant to keep other regional lenders out of trouble. Recent data showed money moving from smaller to larger banks in the days after SVB's March 10 collapse, though Fed chair Jerome Powell said last week he thought the situation had "stabilized".