The turmoil resulting from the collapse of Silicon Valley Bank (SVB) and the forced takeover of Credit Suisse (CS) in March appears to have been contained as result of swift action by central banks and the financial authorities. Measures of financial stress have eased1 and the general expectation is that a full-blown financial crisis akin to that seen in 2007-08 will be avoided.
Nevertheless, the fallout from recent volatility is still likely to have a significant impact on the economic outlook. A key manner in which this could happen is via tighter bank lending standards, higher commercial bank interest rates and a reduced pace of loan growth.
Several factors could bring this about. Although most banks have not witnessed the scale of customer deposit withdrawals that precipitated the demise of SVB – panicked customers tried to withdraw US$42 billion from the troubled bank on 9th March2 – there has been a notable outflow of deposits from both small and large banks3.
Deposit outflows have been triggered by concerns regarding the safety of uninsured deposits (the official ceiling for insured deposits in the US still stands at US$250,000, even though in the case of SVB the Federal Deposit Insurance Corporate acted to protect all deposits4) and the fact that depositors can generally earn a better rate of interest in so-called money market funds. This reduction in bank deposits could in turn lead to a shrinkage in banks’ balance sheets and, ultimately, a fall in lending.
In addition, the prospect of increased regulatory oversight of small and mid-sized banks in the US could make banks more wary of extending credit. One reason cited for the failure of SVB was that, as a regional bank with less than US$250 billion in assets, it was subject to less rigorous capital and liquidity rules than bigger, systemically important financial institutions. In anticipation of new regulations, loan officers at small and mid-sized banks might adopt a more cautious approach to lending.
Indeed, amidst growing concerns about a possible recession following the US Federal Reserve’s aggressive interest rate hikes over the last year or so, survey data suggests that banks were already tightening lending criteria prior to the collapse of SVB5.
Finally, a squeeze on bank profitability is also likely to curtail loan growth. Increased funding costs, as some banks are forced to pay higher interest rates to keep hold of deposits, are likely to squeeze net interest margins, as will a need to hold more liquid, shorter-duration assets if regulations are tightened up6. A possible increase in deposit insurance premiums could also increase costs for banks. According to academic studies cited by Goldman Sachs, each 10% decline in bank profitability reduces lending by around 2%7.
Feeling the squeeze
In turn, a pull-back in lending by small banks in the US could have a significant impact on the US economy. According to Goldman Sachs, banks with less than U$250 billion in assets account for roughly 50% of U.S. commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending and 45% of consumer lending8.
Certain sectors could be hit harder than others. SVB played a key role in lending to start-ups, in the tech sector and beyond, and its demise could leave some new businesses struggling to raise funds. If new sources of capital do not emerge, reduced funding to such start-ups could ultimately impact the pace of innovation and productivity growth.
The high share of lending to the commercial real estate (CRE) sector accounted for by small banks has also raised concern that property companies – already struggling with rising borrowing costs and high office vacancy rates as a result of increased remote working – will face difficulties in rolling over debt.
Some property sector analysts have warned of a ‘doom loop’ whereby a reduction in small bank lending causes defaults on CRE loans to rise, in turn triggering a decline in property prices which then leads to banks increasing their loan loss provisions and curbing lending further9. Reflecting worries about the sector, yield spreads on commercial mortgage backed securities (CMBS, a security backed by a bundle of commercial property loans) have risen sharply in recent weeks10.
Some industry observers are optimistic that problems in the commercial property market will not cause a systemic crisis. For a start, banks are better capitalized than prior to the great financial crisis (GFC). Moreover, the lower loan-to-value ratios that have prevailed in recent years should improve the chances of borrowers being able to refinance loans and mean that if defaults do occur, bank losses will be contained11. One estimate suggests that US commercial property prices would have to fall 40-50% before banks experienced losses on their loans12.
Growth headwind
Even so, there are already tentative signs that lending standards in the broader economy are starting to be tightened. The March survey from the National Federation of Independent Business (NFIB) showed that it was becoming more difficult for small businesses to secure lending, with credit conditions at their tightest since December 201213. Small businesses play a crucial role in driving the US economy; companies with fewer than 100 employees account for 35% of private sector jobs and a quarter of gross domestic product (GDP) according to Goldman Sachs14.
Furthermore, whereas large companies can access capital via equity and corporate bond markets, smaller companies are more reliant on credit from banks, and small banks in particular. As a result, small companies are particularly vulnerable to any tightening in credit criteria going forward, with a reduction in lending likely to have detrimental effects on hiring and investment spending.
There are also indications that consumers are finding it more difficult to access credit. The March Banking Conditions Survey from the Dallas Fed reported a fall in consumer loan volumes as credit standards continued to tighten sharply15.
These developments could usher in weaker spending. As excess savings built up by households during the pandemic are run down and eventually depleted, tighter credit conditions seem set to become an increasingly significant factor in constraining consumer demand in the months ahead.
All of this will weigh on GDP growth going forward, although judging the precise impact is subject to a high degree of uncertainty. JP Morgan reckon that if small bank loan growth grinds to a halt with no offset from large banks, GDP would be cut by 0.5-1.0% over the course of a year16. Similarly, according to the minutes from the Fed’s March policy meeting, economists at the US central bank anticipate that the fallout from recent developments in the banking sector will tip the economy into a mild recession later this year .
Interest rate outlook
Against this backdrop, investors have revised down their expectations for the path of US interest rates going forward. The rationale is simple: if tighter bank lending standards serve to cool the economy, and ultimately bear down on price pressures, the implication is that the Fed will not have to raise interest rates as high as it otherwise would have done to bring inflation under control.
Prior to the SVB collapse, futures markets saw the Fed’s policy interest rate (currently at 4.75-5.0% ) peaking at around 5.6%, whereas rates are currently seen topping out just above 5%19. Moreover, in contrast to Fed policymakers’ expectation that rates will stay above 5% this year20, investors anticipate a cut in the Fed Funds policy rate to around 4.4% by the end of 202321.
This divergence in part reflects the considerable uncertainty regarding the impact of recent events and the non-negligible risk of a renewed flare up in financial stress and/or a marked downturn in the economy.
Elevated levels of uncertainty will mean that interest rate decisions will be even more dependent on the incoming data during the coming months, and indicators of bank lending conditions and loan growth will become an increasingly important focus of attention for both central bankers and investors alike.
18th April 2023
1 https://fred.stlouisfed.org/series/STLFSI4
2 https://fortune.com/2023/03/11/silicon-valley-bank-run-42-billion-attempted-withdrawals-in-one-day/
3 https://www.investors.com/news/u-s-bank-deposits-fall-for-10th-straight-week-as-worries-continue/
4 https://www.forbes.com/sites/marisadellatto/2023/03/12/fdic-will-protect-all-silicon-valley-bank-deposits-after-sudden-collapse-treasury-says/?sh=ed87a72216c2
5 https://www.federalreserve.gov/data/sloos/sloos-202301.htm
6 https://global.beyondbullsandbears.com/2023/03/23/quick-thoughts-how-is-the-svb-and-credit-suisse-crisis-affecting-the-us-and-european-banking-industry/
7 https://twitter.com/MikeZaccardi/status/1643621056916094976/photo/1
8 https://www.goldmansachs.com/insights/pages/stress-among-small-banks-is-likely-to-slow-the-us-economy.html
9 https://financialpost.com/executive/executive-summary/banks-commercial-real-estate-doom-loop
10 https://twitter.com/GunjanJS/status/1644341813568831489/photo/1
11 https://www.axios.com/2023/04/12/commercial-real-estate-regional-banks-loans-maturing
12 https://www.cohenandsteers.com/insights/the-commercial-real-estate-debt-market-separating-fact-from-fiction/
13 https://uk.finance.yahoo.com/news/us-small-businesses-face-worst-100000769.html
14 https://www.goldmansachs.com/insights/pages/smaller-businesses-and-towns-are-likely-to-be-hit-hardest-by-bank-turmoil.html?chl=em&plt=briefings&cid=414&plc=intro
15 https://www.dallasfed.org/research/surveys/bcs/2023/bcs2302
16 JP Morgan – Move fast and break things - 16th March 2023
17 https://www.federalreserve.gov/monetarypolicy/fomcminutes20230322.htm
18 https://tradingeconomics.com/united-states/interest-rate
19 https://twitter.com/SoberLook/status/1646441800805097472
20 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230322.pdf
21 https://www.chathamfinancial.com/technology/us-forward-curves