The regional banking industry has been weathering a tempest this year, and while it may have moved past the most critical stage, it isn’t out of the woods just yet. Noted economist Mohamed El-Erian warns that the sector could potentially relapse if the Federal Reserve fumbles on policy yet again.

“Consider it as a patient in the hospital. Certain banks are still struggling to adapt their models to the current economic climate,” El-Erian explained during a recent Bloomberg Television interview, highlighting the pressure faced by small and mid-sized lenders in the U.S.

The banking sector’s woes became evident in March when Silicon Valley Bank and Signature Bank crumbled under pressure, marking the first instance of lenders being seized by federal regulators since the global financial crisis.

El-Erian, the chief economic adviser at Allianz, emphasized the importance of aiding these ‘hospitalized’ banks in their recovery. However, he cautioned that another misstep by the Fed could send the patient, i.e., the banking sector, straight back into intensive care.

The Fed’s rapid series of interest rate hikes has been a significant factor blamed for this year’s bank failures. For instance, SVB’s bond holdings plummeted in value after the Fed began increasing its key interest rate from a base of zero percent in March 2002. The forced liquidation of SVB’s bond portfolio led to massive losses, sealing the bank’s downfall.

The repercussions were felt across regional lenders, with depositors withdrawing hundreds of billions of dollars collectively from banks like PacWest and First Republic Bank this year. However, recent data from Fitch Ratings indicates a stabilization in weekly deposit flows, suggesting the tide may be turning.

El-Erian has long critiqued the Fed’s response to surging inflation, arguing that its belated and rapid attempts to rein in inflation to its 2% target with swift rate hikes have been detrimental. With the tenth consecutive rate increase issued in May and the looming threat of a recession, the banking sector’s recovery remains precarious.

So, what would a policy misstep entail in El-Erian’s view?

“If we disregard the reality that achieving the 2% inflation target is not a cakewalk, and we pursue it too aggressively,” he said, adding that such a move could lead to a new set of casualties in the financial sector, such as businesses in the commercial real estate market. As such, careful navigation by the Fed is crucial to prevent the patient from being rushed back to the ICU.