Stuart Paterson

IN the words of American economist Ben Bernanke, “credit has the ability to build a modern economy, but lack of credit has the ability to destroy it, swiftly and absolutely.”

If credit is the lifeblood of the financial system, then liquidity is like oxygen; we don’t think about how much we need until its supply is withdrawn.

During March we saw the first signs of stress in the banking sector after last year’s fierce turn in monetary policy. The failure of a number of US regional banks and the near collapse of Credit Suisse has tested the resilience of the global financial system.

After an arduous year for virtually all asset classes in 2022, risk sentiment returned to financial markets this year on renewed hopes that inflationary pressures had peaked and interest rate hikes may be nearing a conclusion.

Market concerns of recession were lessened in the face of incoming economic data which showed, somewhat remarkably, that the US economy was showing resilience to interest rates being some 4.25 percentage points higher in the space of just nine months.

However, dramatic market moves, the likes of which we saw in 2022, rarely come without consequences. The high-profile crises were specific to those institutions, yet these episodes underline how “credit” is built on confidence and trust. Once this disappears so too does liquidity.

This situation is quite different to the 2008 global financial crisis. Some regional banks in the US faced pronounced liquidity challenges as depositors sought higher interest rates elsewhere – a very different scenario to the large and permanent credit losses faced by systemically important banks during the credit crunch.

Previous crises seem to have taught policymakers just how important it is to act both quickly and decisively.

The US Federal Reserve’s Bank Term Funding Program was the appropriate response to shore up confidence and prevent this liquidity issue from escalating into a wider credit event, effectively fulfilling its role as lender of last resort.

However, the very real consequences for the global economy cannot be ignored. While the potential spillover effects are likely mitigated after over a decade of rehabilitation for the financial sector, financial conditions have tightened as banks reign in on their lending standards to preserve their capital and liquidity.

By choking credit creation and regulating the flow of financial oxygen to the real economy, one would expect a slowdown in growth. The question remains as to how pronounced this will be.

Whether an unintended consequence of central bank policy or not, this is perhaps the very remedy required to bring inflation back to an acceptable level.

Markets have taken this in their stride and have rallied strongly, but central banks now face a difficult trade-off between financial stability and price stability. Prioritising the former in the absence of any meaningful slowing of the economy could well frustrate those hoping for ‘peak inflation’.

Events such as these serve as a reminder to focus on quality assets and diversification.

Despite the events that unfolded in March, global equities have shown resilience and remain in positive territory for the year-to-date. While a global financial crisis is not expected, uncertainty and volatility will continue to drive market performance in the short run.

This will make it difficult to position with strong conviction and therefore make the need for diversification more important than ever.

Stuart Paterson is executive director at Julius Baer International