Banking crisis: What it means for interest rates

Is this a passing squall in the banking market or something more serious?

This is what will determine the impact on central bank interest rates – and thus on the borrowing costs facing mortgage holders, businesses and others.

If markets settle down over the next week or so, then central banks are likely to keep on the path of pushing interest rates higher to try to control inflation.

But there is no guarantee that calm will return as investors are now nervous about whether other problems remain hidden in the banking world and, for now, will shoot first and ask questions later in terms of how they trade.

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This is all now about confidence. The European Central Bank (ECB) pushed ahead to increase its key interest rate last week by half a point as it wants to keep bearing down on inflation. But its governing council will also have realised that if it did not go ahead, then investors would reckon it was worried.

Despite ECB president Christine Lagarde saying after last week’s meeting that the ECB would not provide guidance about future interest rates moves – giving it some room for manoeuvre – more hawkish members of the governing council were out in weekend interviews warning that interest rates would continue their upward path.

[ ECB ‘stands ready’ to protect financial stability in Credit Suisse crisis, says Lagarde ]

The financial markets, however, are uncertain. The ECB’s deposit rate – the rate it pays banks who deposit overnight money with it – is now 3 per cent. Earlier this month, before the first banking tremors emerged from the US, investors expected this to rise to 4 per cent by the autumn.

Now markets anticipate only a small increase from the current 3 per cent level – in other words they are currently pricing in the possibility of at most one more quarter-point interest rate rise. We should note that these forward prices swing around a lot and should only be taken as rough indicators.

As well as the change in ECB rate expectations, investors will be closely watching what the US Federal Reserve board, its central bank, does at its meeting this week which ends on Wednesday.

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A couple of weeks ago, markets had expected another half-point rise in US rates to be announced – now they feel that even a quarter-point rise is a 50:50 bet.

Many market analysts argue that European banks are generally solid, with strong capital ratios under regulation tightened up after the financial crash. Irish banks, in particular, have high levels of sticky consumer deposits – which rose sharply after Covid-19 – and do not have high levels of exposure to riskier lending areas such as commercial property.

[ Colm Kelleher: the Corkman leading €3bn takeover of Credit Suisse ]

That said, their share prices have been hit by the crisis and funding markets may be more difficult after the decision to wipe out some bondholders in Credit Suisse, a move which euro zone regulators were quick to say would not apply in the same way in its territory.

So we will have to see how this pans out. “Banking is a confidence game,” as Goodbody Stockbrokers chief economist Dermot O’Leary pointed out in a note to the brokers clients on Monday. “Although it feels like 2008, the capital levels and the regulatory framework in the euro area in particular is in a vastly different place.”

He says that if the crisis passes relatively quickly, attention of central banks must then turn back to addressing the inflation problem.

If this happens and the market situation calms, expectations of future ECB interest rates could switch quickly, pointing again to future more significant increases.

Economist Megan Greene, senior fellow at the Harvard Kennedy Business Scholl, agrees that interest rates will continue to head upwards, given the pressure on inflation. She expects a quarter-point rise from the Fed this week and another ECB hike in May. Beyond that, however, the crisis may mean that ECB rates top up at a lower rate than had been expected. And markets are now pricing in the first cut in US interest rates later this year.

[ There are several reasons to worry about the health of Europe’s banks ]

The ECB has some time before its next meeting to see how this plays out. It will try to walk the line in its public comments between fighting inflation and keeping the financial system sound. The ECB and its regulatory arm have to look both ways at once – saying that European banks are sound, but at the same time that they have all the firepower they need to step in if something goes wrong. They will argue that they have different tools which can allow both the objective of meeting inflation and keeping the financial system safe to be achieved at the same time. Whether this is the case depends on the extent of market pressures. And if higher interest rates start to lead to slower growth on both sides of the Atlantic, this in turn could create pressure for banks as bad debt levels rise.

For now it is clear that central banks want to keep increasing interest rates - and will probably try - but it remains to be seen how much further they can go without setting off more alarm bells. Investors are now alert, searching out where vulnerabilities may lie in the financial system. An interesting few weeks lie ahead with big implications for Irish borrowers.