Banks, credit crunches and the economy

banking

banking

By Michael Klein·May 15, 2023

Fletcher School, Tufts University

The topic:

Financial disruptions in 2008 contributed to the deep economic downturn that became known as the “Great Recession.” Could current bank failures also lead to a recession? The $532 billion in assets from the three banks that failed in March and April 2023 exceeds the inflation-adjusted $526 billion in assets from the 25 banks that failed in 2008. In addition, there are concerns that the crisis may not be contained, and other mid-sized banks could also fail. However, the current situation differs in many respects from the economic conditions at the beginning of the Great Recession. Nonetheless, this and other experiences show how financial distress can lead to macroeconomic weakness, which then contributes to further financial distress and leads to a downward spiral in which credit is tightened, investment is curbed and growth falters.

A banking crisis can have negative consequences for borrowers and the economy as a whole.

The facts:

• One cause of the banks’ recent vulnerabilities is the rapid rise in interest rates. The Federal Reserve has attempted to bring down inflation by raising interest rates at the fastest rate since the 1980s, from near zero in March 2022 to a range of between 5% and 5.25% in May 2023. The sudden transition to higher interest rates leads to fragility in the banking sector. Banks borrow and lend short-term deposits and invest in securities at fixed long-term interest rates. As interest rates rise, the value of banks’ existing portfolios falls as new investments at higher interest rates become more attractive. According to one estimate, the market value of assets in the US banking system is $2.2 trillion lower than the book value of assets, which accounts for held-to-maturity loan portfolios. These book losses are realized when banks have to sell these assets to cover depositor withdrawals. While banks struggle to maintain deposit levels, depositors are less willing to put their money in low-yielding checking and savings accounts as more opportunities for higher interest rates become available.
• Previously failed banks had specific weaknesses that made them particularly vulnerable. Silicon Valley Bank (SVB) was particularly exposed to the risk of rising interest rates because it was heavily invested in longer-dated government bonds, which fell in market value as interest rates rose, and its management failed to hedge against this risk. The SVB was also particularly vulnerable to a depositor run, with over 90 percent of the value of its deposits exceeding the $250,000 guaranteed by the federal government through the Federal Deposit Insurance Corporation (FDIC). Depositors with accounts in excess of this guaranteed amount, both individuals and corporations (whose accounts were used for payroll, among other things), are only partially protected in the event of a bank failure, giving them an incentive to do so at first Signs of difficulty withdrawing money. In addition, depositors were connected through business and social groups, so the news spread quickly and set the stage for a classic Twitter-speed bank run. Also, Signature Bank had about 90% of its assets uninsured and its portfolio was heavily focused on crypto deposits. Both banks were growing very quickly and had inadequate risk and liquidity management practices. Although regulators had expressed concerns about these risks, they had not taken more vigorous action to address them, according to a GAO report. The First Republic Bank, which failed most recently, catered to wealthy depositors and, as a result, also had a high proportion of uninsured deposits, making it more vulnerable to a bank run as its bonds depreciated as interest rates rose (see here).
• Commercial banks reduce lending when their deposits fall or they are otherwise unable to meet regulatory requirements. Deposits are an important source of bank lending ability. When a bank’s deposits fall, it has fewer resources to lend since other sources of funding are less readily available. A bank may also cut lending to comply with regulations such as meeting or exceeding the capital adequacy ratio. Regulators require banks to have enough capital reserves to absorb a specified amount of loan losses. The capital adequacy ratio decreases when loans default and the bank sees a decrease in its loan loss reserve. The bank can then increase its capital adequacy ratio by using funds that would otherwise be used for commercial lending, or by reallocating loans to other assets that are less risky (such as government securities). There is evidence that this effect contributed to the reduction in bank credit in New England during the 1990–1991 recession, when there was a collapse in that region’s housing market. A bank may choose to reduce lending if it has solvency concerns, even if it has not yet met the formal capital adequacy ratio requirement.
• A fall in bank lending may be due to a fall in banks’ supply of credit for the reasons outlined above, or a fall in credit demand that has little to do with banks’ ability to lend — and this distinction is important in understanding whether this is the case There is a credit crunch. A credit crunch occurs when borrowers who would otherwise be able to obtain credit are prevented from obtaining credit because of bank lending restrictions. However, a fall in bank lending could also be due to a fall in borrower demand for credit. Researchers have used a variety of methods to identify when there is a credit crunch rather than just lower demand for credit. For example, a credit crunch could be identified by looking for different borrowing, employment, and performance patterns of bank-dependent firms versus firms that have access to financing through bond or equity markets. Companies dependent on banks tend to be smaller than those that have access to other types of financing. Researchers have also used information from bank auditors to identify banks that are facing regulatory restrictions and therefore need to cut lending. A third strategy uses data from Japan, where large companies rely on funding from a main bank. These banks have been downgraded at different points in time, and a company’s foreign investments have been shown to decline as its respective main bank is downgraded, even as companies linked to healthier banks take advantage of those investment opportunities abroad.
• According to recent data from the Federal Reserve, there are indications that bank lending is tightening and demand for credit is falling in the wake of the recent banking turmoil. The Board of Governors of the Federal Reserve releases quarterly the results of an opinion poll of senior bank loan officers. The latest survey was sent to 65 domestic banks at the end of March 2023 and responses should be submitted by April 7. This question asks whether banks have tightened lending standards, which broadly indicates a credit crunch in lending. Another sentence asks whether banks are reporting stronger demand for credit. The chart shows the net percentage of banks responding that lending standards have tightened and the net percentage responding that there has been greater demand for credit (the net percentages are those that responded tightened minus those that were relaxed, respectively). .those who answered more strictly, minus those who answered weaker). The chart shows that the last two years have been characterized by both a tightening of lending standards and a decline in credit demand.
• Credit crunch due to banking problems can hamper investment and economic growth. An early and influential analysis by Ben Bernanke, who later chaired the Federal Reserve and served during the Great Financial Crisis of 2008, analyzed the impact of bank failures during the Great Depression. He found that bank failures had a particularly strong effect in reducing household, farmer and small business borrowing during this period, contributing to the severity and duration of the Great Depression. The banking system has since been made more resilient, but there is still evidence of the impact of a credit crunch on regional economies. For example, researchers have studied the 1990-1991 recession, when New England real estate values ​​collapsed, and found that the banking weakness at the time impacted small and medium-sized businesses in the region. Regarding the current situation, the IMF’s April 2023 Global Financial Stability Report (p. 3) states that the credit crunch in the United States could reduce lending by 1 percent, which would reduce GDP growth by almost 0.5 percentage points.

Finance is important to the functioning of the economy and banks are an important source of finance for many households and small and medium-sized businesses. Banks can get into trouble as a result of loan defaults or the flight of depositors. A current concern is the exposure of banks to commercial real estate lending given the weakness of that market in the wake of COVID and much more work from home. Vulnerable banks can force borrowing cuts that slow economic growth. Although the current situation is not comparable to the early 1930s, when widespread bank failures played a major role in destroying the economy – banks are now better regulated and safer, and other forms of financing have evolved – a banking crisis could still have adverse consequences for dependent banks, borrowers and the overall economy have.