In March 2022, the US Federal Reserve, facing US headline inflation of 7.9% in year-on-year terms, embarked on a renewed rate-hiking cycle. Fast-forward to today, we have witnessed a total of ten rate hikes ranging from 0.25% to 0.75%, resulting in a cumulative tightening of 5% over the course of a bit more than a year.
At the same time, US headline inflation has decelerated to 5.0% as per March 2023. Until last month, the US economy was showing remarkable resistance against the backdrop of one of the most violent resets of the cost of capital since World War II. Though last October’s near collapse of UK pension funds was a foretaste, it has taken a whole year, since March 2022, for the first potentially systemic cracks to appear.
The recent crisis triggered by a run on Silicon Valley Bank deposits initially appeared to be limited to a small number of US regional banks with a rather specific business model and depositor base. However, as the focus shifted to the extent to which former President Trump had repealed the Dodd-Frank Act in 2018, market participants realised that the problem was more complex than a few banks failing to adhere to the basic principles of asset-liability management.
Inadequate stringency for smaller banks
The Trump administration’s changes centred around an increase in the threshold above which a bank is considered systemically important (from USD 50 billion to USD 250 billion) and therefore subject to enhanced regulatory oversight. Smaller US banks were thus able to fly under the radar and were not subjected to adequate liquidity stress tests. In retrospect, this significantly impaired the stability of the financial system, all the more so as bank runs today can happen at record speed due to digital banking.
Fortunately, regulators on both sides of the Atlantic recognised the potentially systemic implications of the situation early on and intervened decisively. While the crisis appears to have been contained for now, we recognise that the probability of a recession in the US has increased significantly, as credit conditions are inevitably bound to tighten further.
The latest survey report of the National Federation of Independent Business shows that the availability of credit for small businesses is deteriorating sharply in the US. We are entering a phase where the normalisation of the cost of capital in the system is starting to bite more seriously. Business models that were built during the ‘cheap money’ era on the premise of having access to perpetual funding at very low or even zero interest rates are now being ruthlessly exposed. Only when the tide goes out do you discover who has been swimming naked.
Slump in private sector credit growth
As the banking turmoil unfolded, the Federal Reserve moved quickly to deploy the full power of its balance sheet to prevent a liquidity crisis. In particular, the newly established Bank Term Funding Program (BTFP) allows affected banks to borrow cash for up to one year against high-quality collateral that has suffered significant mark-to-market losses. Owing to the full range of liquidity facilities available at the Fed, its balance sheet expanded significantly from mid-March, from USD 8.34 trillion to USD 8.73 trillion, before finally shrinking again to USD 8.63 trillion at the latest reading, suggesting that liquidity stress has been sufficiently brought under control.
Nevertheless, the US regional banking sector has come under intense scrutiny in the wake of recent events. Smaller US banks have recently suffered disproportionate deposit outflows, reducing access to cheap funding, as depositors have found higher short-term yields elsewhere (e.g. in money market funds and Treasury bills) or have simply decided to move their funds to larger, more regulated banks.
This clearly represents a structural impediment to the profitability of the US regional banking sector, as they will either have to offer higher deposit yields or raise more expensive funding elsewhere. In addition, they will almost certainly face increased regulation now that their maturity mismatch vulnerabilities have been exposed.
Why does this matter?
The US regional banking sector plays an important role from a private sector lending perspective. Indeed, most of the recent credit growth has been driven by smaller US banks, as is evident from growth clearly shooting above the pre-pandemic trend. At the onset of the banking crisis, smaller US banks accounted for 24% of consumer loans, 34% of commercial and industrial loans, 38% of residential real estate loans, and a whopping 70% of commercial real estate loans.
Against the backdrop of the latest turmoil, lending standards will inevitably tighten further. Indeed, when looking at the latest available data, US private sector credit growth started to decelerate across categories. In the last two weeks of March, US commercial bank lending fell by the largest amount on record, by just over USD 100 billion, mainly due to a decline in lending by small banks.
Credit crunch possible but not inevitable
While higher funding costs will put pressure on the net interest margins of affected institutions, concerns have recently arisen about the transmission of a credit slowdown to the broader economy and the possibility of a credit crunch.
While commercial bank lending will remain under pressure given the current financing difficulties, only about 20% of lending in the US is done through the commercial banking system. President of the Federal Reserve Bank of St Louis James Bullard pointed to this fact, which led him to conclude that a credit crunch tipping the US economy into a recession is far from a foregone conclusion.
It is important to note that since the Great Financial Crisis, the ‘heavy lifting’, in particular in corporate lending, has in fact been done by non-banks in the shadow-banking system, a much less regulated part of the financial system. By definition, the shadow banking system is very opaque, with limited public disclosure.
However, given the predominant reliance of most shadow-banking vehicles on short-term funding while simultaneously buying longer-term assets, it is fair to assume that certain segments are meaningfully exposed to interest-rate risks, paving the way for idiosyncratic hiccups further down the road if such risks are not properly hedged. Even if these do not materialise, a slowdown in lending across all channels means that economic activity will face significant headwinds in the second quarter of 2023.