The stress on the global banking system caused by some of the largest bank failures since the 2008 financial crisis has led to only a slight deterioration in the outlook for economic growth in the euro area and the U.K., according to Goldman Sachs Research.
Bank stocks have fallen and financial spreads have widened since the collapse of Silicon Valley Bank and the government-brokered sale of Credit Suisse. But, at least to date, the health of the banking sector in the euro area and the U.K. appears to be holding up, with limited fallout in other parts of the economy, as per a new report written by Goldman Sachs’ European economics team.
“The euro area and U.K. banking systems continue to look resilient on key metrics, and macro measures of contagion (including our Financial Conditions Indices) have only deteriorated modestly,” the authors write. They point to how well European banks are capitalized, with capital ratios exceeding regulatory requirements by healthy margins. The region’s banks also boast strong liquidity and funding positions, and their profitability has been growing, spurred by the positive net interest income they are earning from higher interest rates. “The main drag on economic activity is therefore likely to come from a tightening in bank lending, which is already contracting in response to higher policy rates,” they conclude.
While GS Research acknowledges estimating the response of bank lending to banking stress is difficult, the team set out to quantify the likely impact on lending standards and the ripple effects on broader economic activity. By analyzing the relationship between high-frequency indicators of financial stress and the standards banks use in granting loans, Goldman Sachs Research economists estimated banks might tighten lending by around 10 percentage points in the euro area and the UK — a significant decline in the availability of credit but well below the 50 percentage-point deterioration seen during the global financial crisis. It found that such a tightening would subtract about 0.3% from the level of real GDP in the euro area and about 0.5% in the U.K., before considering the offsetting impact of looser fiscal policy. “Although subject to significant uncertainty, our estimates thus point to a manageable drag on growth from the banking tensions observed so far,” the authors write.
Our economists looked to several other means to support this view: With the help of our banks team, they estimated how much banks might curtail lending in response to a deterioration in their capital ratios; they also considered previous studies that showed modest financial stress usually implies only modest declines in economic activity; and they considered how macro uncertainty in general can weigh on growth.
These alternative analyses yielded similar findings, prompting the team to lower their forecasts for real GDP growth by 0.3% in the euro area over the next year, with their 2023 growth forecast now at 0.7%. The reduction in the U.K. forecast was only 0.2%, as the effects of the more expansionary budget announced by the U.K. government this week offset some of the expected hit caused by the banking stress. The team’s forecast is now for 0.0% growth in the U.K. this year.
There’s one more implication of the fallout, and that’s on central bank policies. Our economists believe both the European Central Bank and the Bank of England will exercise more caution in the coming months as the full fallout from the banking crisis comes to light. They now expect the ECB to hike interest rates by 25 basis points in May, down from the 50 basis points expected before, followed by another 25 basis points in June. They likewise reduced the projected path for rate hikes enacted by the BOE by one 25-basis-point hike. On terminal rates – or the rate at which central banks end the current hiking cycle – the team expects the ECB’s terminal rate to be 3.5%, versus 4.25% for the BOE.
“Given the fluid financial market situation, the uncertainty around our updated central bank calls is large,” the authors write. “Persistence (or intensification) of the banking stresses could convince the ECB and BOE that a sufficient growth drag from the financial system is in the pipeline to stop hiking earlier.”
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