Global financial stress accelerated over the weekend, requiring coordinated action by central banks to stem dollar funding pressures in financial markets as investors digested the forced merger of Credit Suisse and UBS.
Large additional tier one bondholder losses amid the $275 billion European market in such capital will most likely trigger large capital flows in the coming days that may cause turmoil across global markets.
To ensure that clearing and payments can continue a global scale—they depend on the availability of the U.S. dollar in the global financial system—the central banks issued a rare joint statement on Sunday.
The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing coordinated action to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements. To improve the swap lines’ effectiveness in providing U.S. dollar funding, the central banks currently offering U.S. dollar operations have agreed to increase the frequency of 7-day maturity operations from weekly to daily. These daily operations will commence on Monday, March 20, 2023, and will continue at least through the end of April.
The network of swap lines among these central banks is a set of available standing facilities and serve as an important liquidity backstop to ease strains in global funding markets, thereby helping to mitigate the effects of such strains on the supply of credit to households and businesses.
We still anticipate that the Fed will hike its policy rate by 25 basis points this week.
At this time, we still anticipate that the Federal Reserve will hike its policy rate by 25 basis points at its meeting this week.
Not moving forward with the expected rate hike would probably be interpreted as a signal of larger problems and create a larger net tightening in financial conditions, even as the recent shock most likely caused a net tightening of 50 to 150 basis points.
Such is the balancing act that the Federal Reserve must strike—price stability, unemployment and growth, and financial stability. Achieving all three would be the difference between a mild and major recession that we expect to begin in the second half of this year.
Our RSM US Financial Conditions Index stood at 1.7 standard deviations below neutral on Friday. An index reading of 2 occurs during periods of severe crisis. We are nearing that point.
The Credit Suisse-UBS merger essentially required Switzerland’s central bank to put up $100 billion to get the approximately $3 billion deal done and prevent a disorderly unwinding of a global systemically important financial institution.
While shareholders in the deal took large losses, many were not wiped out, although approximately $17.3 billion in additional tier one capital was wiped out.
While that number is significant, the size of the European additional tier one capital market is roughly $275 billion, and that number will most likely drive volatility across global asset markets until some sense of clarity can be obtained.
In our estimation, the system worked as it should. Additional tier one capital was designed to be a shock absorber if a bank fails and is intended to impose losses on bondholders or be converted to equity if a bank’s capital ratio falls below levels imposed by regulators.
Different in the U.S.
It is important to note that the challenges in the European banking sector are quite different from those in the American banks.
Although the common denominator is duration risk or risk around unrealized losses because of interest rate risk management, the focus in Europe is on a far more systemic problem. Large holdings of negative-yielding debt sit on the balance sheets of European banks.
In the United States, it is likely that the focus will turn to leverage in the banks, shadow banks and private equity companies in addition to exposure to commercial real estate holdings that will need to be rolled over this year and next.
Although Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen also issued a joint statement reaffirming that capital and liquidity positions in the American banking system remain strong, speculators will almost certainly try to identify and exploit weakness in the coming days.
