The recent banking sector turmoil has caused lenders to tighten borrowing standards, squeezing the supply of credit to households and businesses, potentially threatening economic growth, according to a report from the Federal Reserve.
The report showed that a net 46 percent of banks tightened credit terms for a key category of business loans for medium and large businesses. That’s a relatively modest increase compared to 44.8 percent during the final quarter of 2022.
Credit conditions for small firms stiffened more substantially, however, with a net 46.7 percent of bank reporting more stringent lending terms compared to 43.8 percent in the earlier survey.
Bank also reported that there was less demand for loans from firms of all sizes in the first quarter compared to the one prior.
He added that the report “confirms there’s a lot more trouble ahead.”
On the consumer side, lending standards tightened for all loan categories, according to the SLOOS survey. Consumer demand weakened for auto loans, though it remained essentially unchanged for credit cards.
Economic Slowdown
It’s unclear how much of the lending squeeze can be attributed to the accumulated impact of the Federal Reserve’s aggressive monetary tightening and how much of it can be chalked down to the banking sector turmoil sparked by the collapse of Silicon Valley Bank (SVB) and other bank failures.Treasury Secretary Janet Yellen said during an interview on CNBC on Monday that the credit crunch is partly a natural outcome of the Fed’s current rate-hiking cycle.
“There has been an ongoing tightening of lending conditions. And that is part of the process by which monetary policy works,” Yellen said in response to a question about the SLOOS report.
“The Fed is aware that tightening of credit conditions is something that will tend to slow the economy somewhat. And I believe they are taking this into account in deciding on appropriate policy,” Yellen added.
In a bid to quash soaring inflation, the Fed in March 2022 embarked on its fastest pace of raising interest rates since the 1980s.
The brisk pace of rate hikes hit the U.S. midsize bank sector particularly hard as their asset portfolios were dominated by government bonds whose mark-to-market value dropped as rates increased.
The California-based Silicon Valley Bank failed at the beginning of March after depositors rushed to withdraw their money amid fears about the bank’s health.
About 94 percent of SVB’s deposits were uninsured, and when depositors got wind of SVB taking a $1.8 billion loss on bond sales that had decreased in value due to the Fed’s rapid rate hikes, they rushed for the exits.
Risks to Financial Stability
The fallout from SVB’s collapse drove increased deposit outflows from smaller U.S. banks, with deposits falling by a record amount during the week following the bank’s failure.Signature Bank was the next bank to topple, followed sometime later by First Republic, fueling concerns about the health of the regional banking sector and sparking fears of a credit crunch.
“A sharp contraction in the availability of credit would drive up the cost of funding for businesses and households, potentially resulting in a slowdown in economic activity,” the report added.
‘Expect Other Banking Crises to Happen’
Lucrezia Reichlin, professor of economics at the London Business School, told the International Monetary Fund’s Finance and Development blog that there are likely to be more bank failures going forward.“I expect other banking crises to happen, especially if central banks continue to tighten monetary policy,” she said. “Banking crises cannot be prevented in all contingencies, at least not in a fractional reserve system where loans don’t need to be fully backed by deposits, like the system we have today.”
“The recent crisis is a painful reminder of the fundamental instability of banks’ business model,” she continued, adding that, in principle, regulators have the necessary tools to deal with the failure of a single bank. But in the event of a broader crisis involving multiple collapses, there are questions about the adequacy of the current crisis management framework.
“Today, if the world economy were to plunge into a deep recession, we are likely to see many cases of institutions facing solvency problems that will test this assertion,” she said.
Reichlin said that a tightening of lending conditions is a natural outcome of the Fed’s rate hikes.
“When former chair of the U.S. Fed Paul Volcker was asked by former Fed vice chair Alan Blinder how he thought monetary policy worked to crush inflation, he replied, ‘by causing bankruptcies,’” she said.
“Some parts of the system will run into solvency issues as a consequence of monetary policy tightening,” she added, noting as an example the savings and loan crisis that followed the Fed’s tightening cycle in the early 1980s.
“In principle, regulators can prevent these crises, but history proves that regulators are often behind the curve,” she said.
While she expressed confidence that U.S. financial authorities would act to stem the fallout from any potential crisis, a key “question is whether these crises can be handled without costs for the taxpayers.”
Meanwhile, shares of regional banks PacWest Bancorp and Western Alliance fell on Tuesday, leading some of their peers in early trading as regional bank stocks resumed their decline after a two-day rally.
Regional bank stocks have been under pressure since the collapse of SVB and others, with investors appearing unnerved by deposit outflows and broader fears about financial instability.
