Could the pandemic trigger another banking crisis?

• The coronavirus-related recession will lead to a marked increase in defaults on bank loans but, while that will hit earnings and justifies the sharp sell-off in banking stocks, the greatly improved financial health of banks means that we don’t believe this represents a systemic risk to the banking system. In particular, we think the risk of a GFC-style adverse feedback loop developing – in which mounting losses in the banking system trigger a further contraction in credit, additional asset price declines and, consequently, even greater loan losses – is quite low.
• The increase in the spread between unsecured three-month LIBOR and the corresponding T-bill rate has raised fears of a renewed crisis in bank funding. But it is important to remember that LIBOR is being phased out and isn’t a particularly useful gauge of anything these days given how low trading volumes
• have fallen. Its replacement, the Secured Overnight Funding Rate (SOFR), which is basically a repo rate, indicates that borrowing costs have fallen to zero and, in particular, there has been no repeat of the temporary liquidity shortage that caused a spike in rates last September. (See Chart 1.) Even three-month
• LIBOR is lower than it was a month ago, it just hasn’t fallen as much as the corresponding T-bill rate. 
• Commercial bank’s balance sheets are much stronger than they were in 2008. In part thanks to the Fed’s bigger balance sheet, overall deposits are far bigger than overall loans, banks are holding a lot of cash, which is mostly reserve balances held at the Fed, and short-term borrowing is roughly the same size as it was in 2008, even though the overall size of banks’ balance sheets is now double what it was back then. (See Chart 2.) The loan-to-deposit ratio remains below its historical average and is a long way off the record high going into the 2008 crisis.

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