The banking crisis risks severe spillover across the financial sector and beyond, Moody's says

• Moody's expects the bank crisis to be contained by the actions from policymakers.
• But there's still a risk it produces spillover effects that go beyond the bank sector, it added. 
• If that happens, the result would be greater financial and economic damage, the ratings agency said.

Fallout from the bank turmoil that began with Silicon Valley Bank earlier this month still carries the risk of spilling over, even though policymakers responded quickly to the crisis, according to Moody's. 

In a Thursday note, strategists from the ratings agency said they broadly expect the Federal Reserve and other regulators to be successful in containing ripple effects, but the potential for broader stress remains.

"[I]n an uncertain economic environment and with investor confidence remaining fragile, there is a risk that policymakers will be unable to curtail the current turmoil without longer-lasting and potentially severe repercussions within and beyond the banking sector," Moody's wrote.

Even prior to the bank crisis, it had forecasted global credit conditions to weaken in 2023 as monetary policy tightening weighed on growth and caused recessions in some countries.

But now, the longer that financial conditions remain tight, the odds grow that stresses expand beyond the bank sector, causing greater financial and economic damage than what Moody's anticipated.

The note listed three main channels through which spillover could occur: exposure to troubled banks, increased risk aversion by market participants, and policy risk.

A "retrenchment in credit by banks" and heightened risk aversion, Moody's said, would impact liquidity-constrained entities most directly, but it would also cause lenders and investors to be increasingly cautious. 

"In this environment, as the recent bank failures exemplify, there is a potential for shocks arising from interest rate risk, asset-liability mismatches, high asset or liability concentration, poor governance, low profitability, higher leverage and vulnerable business models," the note said, adding that banks aren't the only institutions with exposure to these shocks.

Meanwhile, with the Fed hiking interest rates Wednesday by another 25 basis points, policymakers still face further challenges.

The bank tumult complicates the Fed's year-long battle with inflation, and makes it harder to achieve a soft-landing, the strategists said.

"In our baseline forecasts, we expect policy responses to be rapid as risks emerge, thus preventing entity-level risks from becoming systemic," according to Moody's. "But calibrating policy remains challenging, which raises the risks that policy missteps, limitations or unintended consequences could result in a further deterioration of the credit environment."