Smaller Banks’ Critical Role in Economy Means Distress Raises Recession Risks

Main Street businesses and American families are likely to find it harder to get a loan because of turmoil in the banking industry, denting economic growth and raising the risk of a recession.

“Once there is stress in a particular set of institutions, then those institutions and those that have similarities will tend to be more cautious in their lending,” he said. “We’re likely to be in this state for a prolonged period.”

Smaller banks are crucial drivers of credit growth, the fuel that powers the economy. Banks smaller than the top 25 largest account for around 38% of all outstanding loans, according to Federal Reserve data. They account for 67% of commercial real estate lending. 

Aggressive moves by the federal government and Wall Street to calm these fears are intended to stave off a wider crisis. But the possibility that other banks have similar problems has triggered a selloff of financial stocks as investors scrutinize bank solvency. This, in turn, stoked public alarm about the safety of deposits and the size of unrealized losses.

Smaller banks are likely to respond by tightening standards and slowing lending to raise capital ratios, said

Torsten Slok,

chief economist at Apollo Global Management Inc., a private-equity firm. He said those moves would brace against the risks of more fickle depositors and volatile funding costs.

“If it’s suddenly much harder to get an auto loan, a consumer loan, a mortgage for commercial real estate simply because smaller regional banks have to reorganize balance sheets,” Mr. Slok said, “then you run the risk that many people won’t get the financing to buy that car, to buy that washer, and that corporate lending takes a hit.”

He expects the U.S. economy to enter a recession by the middle of this year triggered by a pullback in lending from smaller banks.

Until the SVB failure, Mr. Slok had expected a “no landing” scenario, meaning the economy would keep growing, despite signs of slowing. “But add this risk to small and medium-sized banks, and we’re headed for a hard landing,” he said, or a painful downturn.

Silicon Valley Bank collapsed in less than two days. In that time, its stock price fell over 60% and customers tried to withdraw $42 billion. Here’s how SVB became the second-largest U.S. bank failure ever and what it means for customers in the future. Illustration: Alexandra Larkin

Mr. Daco also said he believes the SVB fallout has sharply increased recession odds, and he expects one this year. Barring financial meltdown, he expects tighter credit and financial conditions to shave off around 0.5% of GDP over the next 18 months, keeping real growth in gross domestic product essentially flat in 2023, comparing the fourth quarter with the same quarter in 2022. The economy expanded 0.9% in 2022 on the same basis.

Goldman Sachs

economists increased the probability that the economy enters a recession in the next 12 months to 35%, from 25% before the SVB failure.

Regional and smaller banks are important to the overall economy, and certain corners are even more reliant on them for credit, said

Bill Adams,

chief economist at Comerica Bank, a large regional bank based in Dallas.

“The banks that are outside of the largest dozen are more focused on banking services for small businesses and small towns and rural areas,” he said. 

Financial-system turmoil could tighten credit—and ultimately weaken the economy—via several channels. On a basic level, slumping stock and bond markets make funding investments more expensive. More directly, banks might try to heal their balance sheets faster than they otherwise would, said

Daniil Manaenkov,

economic forecaster at the University of Michigan.

“That means that you start making fewer risky loans and if you make them you increase your spreads,” he said. “Credit will become somewhat more expensive.” He added that some investment projects might be delayed, which could translate into less hiring.

Hiring has been strong through the first two months of the year, before the bank failures. Employment losses often lag behind the broader economy since employers tend to cut jobs after making other cost-saving measures. The economy has recently shown signs of slowing, including a decline in retail spending in February. 

Banks had begun tightening lending standards at the end of last year, as the sharp rise in interest rates made it harder to find creditworthy borrowers, and demand for commercial loans weakened, according to a Fed survey of senior loan officers. 

The SVB fallout will likely intensify that tightening, which bodes ill for the job market because it slows expansions and investments, said

Padhraic Garvey,

ING Bank’s regional head of research for the Americas. 

“There’s a pretty strong correlation between lending standards and unemployment,” he said.

Write to Gwynn Guilford at [email protected]

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