Critical role of smaller banks in the economy means distress increases recession risks

Main Street businesses and American households will likely have a harder time getting a loan because of the turmoil in the banking sector, hurting economic growth and increasing the risk of a recession.

“The risk in terms of the SVB spark is real,” said Greg Daco, chief economist at EY-Parthenon, a strategic consulting unit of Ernst & Young LLP. The collapse of Silicon Valley Bank triggered fear among depositors that led to the bankruptcy of Signature Bank and the movement to rescue First Republic Bank..

“Once there is stress on a given set of institutions, those institutions and those that have similarities will tend to be more cautious in their lending,” he said. “We are likely to be in this state for an extended period.”

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

Aggressive moves by the federal government and Wall Street to allay those fears are aimed at averting a broader crisis. But the possibility that other banks have similar problems has triggered a financial stock sell-off as investors scrutinize the bank’s solvency. This, in turn, fueled public alarm about the safety of deposits and the size of unrealized losses.

Smaller banks are likely to react by tightening standards and slowing lending to boost capital ratios, said Torsten Slok, chief economist at Apollo Global Management Inc., a private equity firm. He said these measures would protect against the risks of more volatile depositors and volatile funding costs.

“If it suddenly becomes much more difficult to get an auto loan, a consumer loan, a commercial real estate mortgage simply because the smaller regional banks have to reorganize their balance sheets,” Slok said, “then you run the risk that a lot of people no If you can’t get the finance to buy that car, buy that washing machine, corporate lending will suffer.

He expects the US economy to slip into a recession by the middle of this year, triggered by a pullback in lending by smaller banks.

Until the SVB crash, Slok had been expecting a “no landing” scenario, meaning the economy would continue to grow despite signs of a slowdown. “But add that risk to small and medium banks and we are heading for a hard landing,” he said, or a painful slowdown.

Silicon Valley Bank failed in less than two days. In that time, its stock price has dropped more than 60% and customers have tried to withdraw $42 billion. See how SVB became the second-largest bank failure in the United States and what that means for customers going forward. Illustration: Alexandra Larkin

Daco also said he believes the fallout from SVB has dramatically increased the chances of a recession, and he expects one this year. Barring a financial meltdown, he expects credit and tighter financial conditions to reduce around 0.5% of GDP over the next 18 months, keeping real gross domestic product growth essentially flat in 2023, comparing Q4 with Q4 2022. The economy expanded 0.9% in 2022 on the same basis.

Economists at Goldman Sachs increased the probability that the economy will enter a recession in the next 12 months to 35%, from 25% before the SVB crash.

Regional and smaller banks are important to the economy as a whole, and some corners depend even more on them for credit, said Bill Adams, chief economist at Comerica Bank, a large regional bank based in Dallas.

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

Financial system turmoil can tighten credit – and ultimately weaken the economy – through a variety of channels. At a basic level, falling stock and bond markets make financing investments more expensive. More directly, banks may try to recover their balance sheets faster than they would otherwise, said Daniil Manaenkov, an economic analyst at the University of Michigan.

“That means you start making less risky loans, and if you do, you increase your spreads,” he said. “Credit will be a little more expensive.” He added that some investment projects could be delayed, which could translate into fewer hires.

Hiring was strong in the first two months of the year, before the bank failures. Job losses generally lag behind the overall economy, as employers tend to cut jobs after taking other cost-cutting measures. The economy has recently shown signs of slowing down, including a decline in retail spending in February.

Banks began tightening lending standards late last year as rising interest rates made it harder to find reliable borrowers and demand for business loans weakened, according to a Fed survey of top loan executives.

The SVB drop is likely to intensify that tightening, which bodes ill for the job market because it slows expansions and investment, said Padhraic Garvey, ING Bank’s regional head of research for the Americas.

“There is a very strong correlation between borrowing defaults and unemployment,” he said.

Write to Gwynn Guilford at

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