The price of a mistake by the ECB in raising rates would be high

This banking crisis is lingering on and this weekend officials across Europe will be nervy. Pressure on Deutsche Bank, the big German institution on the markets on Friday raises the risk that the crisis will not be contained at the Swiss border and will seep into the European Union. There appears no specific news about Deutsche Bank, which led its shares to fall on Friday and for an increase in the price to investors of insuring against anything going wrong at the bank, beyond the fact that it has had its problems in recent years.

The German government insisted that all was well at the bank and analysts saw no clear reason why it had happened. But the prospect of another green bottle in the global banking wall – and a big one at the heart of the EU – facing pressure on the market is an unnerving reminder of how these things spread. Many EU leaders leaving the latest summit on Friday were loath to talk to the press, apparently for fear of saying something that could worsen the situation. This may all pass, but right now we just don’t know.

[ Deutsche Bank leads slide in European bank shares ]

[ Economic turmoil means finance ministers must rein in spending: Donohoe ]

The story has played out over the past few weeks with the collapse of Silicon Valley Bank (SVB) and Credit Suisse. The sharp rise in interest rates over the past year has been part of this story – particularly in SVB, where the bank was forced to sell holdings on US government bonds at a sharp loss as depositors looked for cash. These bonds fall in value as interest rates rise, though this is generally a big problem only if banks have to sell them quickly.

Since this happened, the real question has been whether the problems would stop there. In the United States this looked unlikely, though it is generally smaller banks which have been under pressure. In Switzerland, the merger between troubled Credit Suisse and UBS is not yet complete and UBS shares are under pressure too.

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This left the big question for the European Central Bank: will this now spread into the euro zone? Has the sharp rise in interest rates left other problems hidden in the European banking sector? The regulators and governments say no, but investors just aren’t sure. And so the nerves around Deutsche Bank are important.

The problem in this situation is that perceptions matter – banks and regulators now have to demonstrate that everything is okay, rather than investors and depositors taking their word for it. As we saw with SVB and Credit Suisse, once confidence is lost there is really no way back. In Europe, we are told, regulation has been tight and banks have substantial financial buffers to deal with any pressures they may face. This story is more persuasive than it was in 2008, but the new system of financial regulation is now facing its first significant test.

The ECB is clearly willing to trigger a recession to bring down inflation – but will it run the risk of fuelling a banking crisis?

What does this mean for Ireland? The Irish banks have been subject to particularly tight regulation, in part a reflection of the legacy of the crash lurking on their loan books as non-performing loans. They are also stuffed with household savings, which are traditionally slow to move. Like institutions elsewhere, Irish banks may face higher costs in raising funds and their share prices are suffering in the general malaise. But they are not the market focus as they were in 2008.

Already, higher interest rates and fears of an economic slowdown have led banks in the euro zone to start setting tougher conditions for loans to businesses and households, according to an ECB survey on the issue. If the banking crisis lingers, then the risk is of a wider credit crunch, as banks tighten up further on who they will lend to and on what terms, further hitting economic growth.

The Irish banks, which haven’t been able to find ways to lend out the vast customer deposits, should not be too exposed here. But the Irish economy generally is obviously threatened by any slowdown in global growth which is brought on by a credit crunch. And remember that borrowers here – and across the euro zone – have still to feel the full impact of the interest rate increases announced so far and this will slow Irish growth too.

It is ironic that part of the goal of central banks in increasing interest rates is to slow the supply of credit and thus hit economic demand and bring down inflation. Now they may be getting a bit more than they bargained for – they wanted a slowdown in lending, not a credit crunch or a banking crisis. The lags in this all feeding through to the real economy make the job of central bankers really difficult. Despite this, the ECB, the US Fed and the Bank of England have all increased interest rates since the banking wobbles started, though investors believe they may not now go much further.

If central banks go too far in increasing interest rates and this leads to a recession, that will create another problem for the banking sector, as bad loans will start to increase again. More rate rise would also risk fuelling nerves in the short term on the markets. This is why markets are now betting that interest rates are near their peak, even as central bankers hint otherwise due to their desire to clamp down on inflation. This is one of watch over the next couple of months.

The price of a mistake by central banks in being seen to trigger further financial turmoil could be high. But what do they do if inflation stays high?

The ECB is clearly willing to trigger a recession to bring down inflation – but will it run the risk of fuelling a banking crisis? The market wobbles on Friday have upped the ante. Communication to the market from central banks and governments is now vital, as are actions to deal with any problems that emerge. The banking crisis is at the euro zone’s border and all the measures put in place after the financial crash to ensure the sector is solid now face their first big test. The squall which started in America has not passed over yet – not by a long shot.