Will Bank Problems Sink the Economy?

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by Forbes

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Will Bank Problems Sink the Economy?

As the shock over runs on Silicon Valley Bank (SVB), Signature Bank and Republic Bank sinks in, investors are now focusing on whether problems with regional banks will tip the economy into recession. Goldman Sachs has upped its probability of recession to 35% from 25%, and Torsten Slok of Apollo Global Management now projects a U.S. recession after previously calling for a "no landing" outcome. Their argument is that small/regional banks, which collectively account for about 40% of all bank loans, are likely to cut back lending which will weaken the economy.

At the press conference following the March FOMC meeting, Jerome Powell acknowledged that banking problems could reduce lending, but he maintained the Fed's paramount goal is to reduce inflation. There is almost a full percentage point gap between where Fed officials see the federal funds rate at year's end versus what the bond market is pricing in.

The outcome hinges on how exposed banks are to deposit flight. During the first two years of the Covid-19 pandemic, U.S. bank deposits increased by about $5 trillion, or 35%, as households and businesses placed the proceeds of government transfer payments with banks. Deposit growth subsequently plateaued last year, as banks did not increase deposit rates materially when the Fed tightened monetary policy. This has left them less competitive than money market funds, which captured most of the $250 billion in outflows from small banks in the first three weeks of March.

Meanwhile, the FDIC estimates that the market value of U.S. bank securities declined by $620 billion last year as bond yields surged. This is substantial considering the total book capital of U.S. banks is $2.2 trillion. However, if banks designate that bonds are being held for maturity, they only have to realize losses on their balance sheets if they are sold before they mature.

In this respect, the problems that SVB encountered are unique in many ways. Most notably, it had an unusually large mismatch in the duration of its assets versus liabilities and its ratio of uninsured deposits exceeded 90%. These attributes left SVB vulnerable to a run when a prominent venture fund tweeted clients of the bank to pull their funds.

The big unknown is how much duration risk other banks took and how much they invested when bond yields were near lows. It is difficult to know because regional banks are not subject to stress tests that apply to larger systemically important financial institutions. Professors Steve Cecchetti and Kim Schoenholtz argue that bank supervisors need to do an immediate review of the balance sheets of the 45 banks with assets in excess of $50 billion to determine their vulnerability to deposit flight.

In general, the more exposed banks are to interest rate risk, the more likely banks will curtail lending. Small banks provide credit to many smaller businesses and start-ups that do not have access to larger banks, and they also play an important role in funding commercial real estate. They had been expanding credit at a double digit pace over the past year. Meanwhile, large commercial banks have been tightening credit standards over the same period, which shows up in the Fed's survey of senior loan officers shown below.

There has also been a significant tightening in financial market conditions as the Fed has raised interest rates. One caveat, however, is there are lags between a tightening of credit and a weakening of the economy. For example, yield spreads between corporate bonds and U.S. Treasuries have remained unusually low until recently. The principal reason is corporate balance sheets - both for investment-grade and high yield issuers - are much stronger today than during the 2008-09 Global Financial Crisis (GFC). Corporate profits have also been robust although they have slowed recently.

Another consideration is credit spreads are a contemporaneous indicator of recession: They widen materially when defaults surge, but this has not happened yet. For example, credit spreads blew out during the GFC when defaults surged but they did not lead defaults materially.

Credit spreads, therefore, could increase if the economy weakens materially this year. Moody's raised its forecast of defaults for high yield issuers in January from 2.0% at the end of 2022 to 6% by the end of this year. Leveraged loans appear riskier because they are variable rate instruments that are also less liquid than bonds, and commercial real estate is under pressure owing to a surge in mortgage rates.

The bottom line is that it will be tougher for many households and businesses to get credit. That said, a full blown "credit crunch" such as occurred in 2008 in which financial institutions are reluctant to accept counterparty risk is highly unlikely. The reason: The largest financial institutions are well capitalized and subject to strenuous stress tests to ensure they have the ability to cope with funding pressures.

In this respect, the assurances of Jerome Powell and Janet Yellen that the financial system is fundamentally sound are valid. Weighing these considerations, if a recession unfolds later this year it is not likely to be prolonged or severe.

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