Top economist Mohamed El-Erian warns that ‘erosion in trust’ caused by banking crisis will lead to ‘economic contagion’

The fractures in the banking system could still have a major impact on Americans thanks to the lingering threat of “economic contagion,” prominent economist Mohamed El-Erian has warned—and there is little policymakers can do to stop it.

In an op-ed for Bloomberg, El-Erian, chief economic adviser at Allianz and president of Queens’ College at the University of Cambridge, warned that “fallout” from the troubled banking sector was adding to the pressure on an already delicate economy.

Questions over the stability of banks in the U.S. and beyond have come into focus in recent weeks thanks to the collapse of Silicon Valley Bank (SVB) and Signature Bank, the forced sale of Swiss lender Credit Suisse to rival UBS, and problems at other U.S. institutions including First Republic Bank.

“Banking is based fundamentally on trust,” El-Erian—who also serves as chair of Gramercy Fund Management—wrote. “Any erosion in trust can, and does, lead to outcomes that were deemed highly unlikely or even unthinkable just a few days earlier.”

Americans’ trust in the banking system has fallen sharply since the failures in the sector, a recent poll found. In response to the collapse of SVB, JPMorgan and other big banks considered too big to fail have raked in deposits as customers reallocate their funds away from smaller lenders.

Former Pimco CEO El-Erian noted in his op-ed that some considered the shift in banking preferences insignificant as the money largely remained in the banking system. However, he warned that even if this was true, it failed to capture the bigger picture.

“The banks receiving the deposits are likely to have different propensities to lend, thereby influencing the scale and distribution of overall lending,” he said.

“This could become a big issue for local communities, regions and sectors that fear that their access to loans will be curtailed because their traditional banking partners will have to shrink their balance sheets after losing deposits. It is also an issue for policymakers.”

He argued that while the Federal Reserve, the Federal Deposit Insurance Corp (FDIC) and the Treasury could calm fears by signaling they were willing to use an array of tools to protect consumers, this was unlikely to immediately and fully reverse the “flow of fleeing deposits.”

This, he said, increased “the risk of a credit contraction that could undermine overall economic activity.”

“Unfortunately, there are no easy and immediate policy measures to offset this new headwind to economic growth,” El-Erian said. “Moreover, the reduction in lending was not supposed to happen so early, if at all, for small- and medium-size companies that have not overborrowed.”

He added: “This economic contagion, which will play out over time, threatens to increase the challenges facing an economy that is dealing with inflation, a mishandled interest-rate hiking cycle, declines in personal savings, bouts of financial instability and a slowing global economy.”

Not alone

El-Erian isn’t alone in issuing warnings about the impact the collapse of SVB and the wider banking crisis might have on the American economy.

Earlier this month, Goldman Sachs said a major downturn was more likely after the banking industry’s problems, raising the probability of a U.S. recession within the next year from 25% to 35%.

Meanwhile, AXA Investment Managers Chief Economist Gilles Moec told news agency Reuters on Wednesday that changes in lending patterns on the back of the banking stress posed an economic threat.

“There is a sizeable risk that the ongoing banking trouble triggers a ‘sudden stop’ in lending which would then send the economy into the sort of recession which would go beyond what is strictly needed to tame inflation,” he said.

This story was originally featured on Fortune.com

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Source: https://finance.yahoo.com/news/top-economist-mohamed-el-erian-095602104.html