The Federal Reserve has warned that the latest banking turmoil could trigger a broad credit crunch that threatens to slow the US economy, while central bank lenders said they plan to tighten lending standards amid concerns about loan losses and deposit flight.
Two separate Fed releases on Monday highlighted growing concerns that the collapses of Silicon Valley Bank and Signature Bank in March and last week’s collapse of the First Republic will lead to a contraction in lending and push asset prices lower.
The US Federal Reserve said in its semi-annual Financial Stability Report that despite “decisive action” by regulators and officials to deal with recent regional banking crises, concerns about “the economic outlook, credit quality and funding liquidity” could mean that “banks and other financial institutions, to further contract the supply of credit to the economy”.
The Fed added: “A sharp decline in the availability of credit would raise the cost of financing for businesses and households, potentially leading to a slowdown in economic activity.”
The possibility of a credit crunch was cited as one of the top current risks to the financial system, rather than the Fed’s most likely scenario. But it reflected concerns about the macroeconomic impact of one of the most turbulent months in American finance since the 2008 global financial crisis.
“The credit crunch, or at least the credit crunch is beginning,” Austan Goolsbee, president of the Federal Reserve Bank of Chicago, told Yahoo Finance on Monday. “I think it has to be said that a recession is possible.”
Fears of a credit crunch come as a potential US debt default looms while the White House and Congress are locked in an impasse over increasing the government’s $31.4 trillion credit limit. An agreement must be reached by early June to avoid a “disaster” for the economy and markets, Treasury Secretary Janet Yellen has warned.
As part of its stability report, the Fed surveyed market experts and academics. The stock, which ranks stress in the banking sector as the top threat to stability, has quadrupled since the fall and is now on par with inflation and US-China tensions. According to this survey, concerns about commercial and residential real estate are also increasing rapidly.
The Fed also released the results of its quarterly opinion poll of senior loan officers on Monday, which showed banks expect to tighten lending standards for the remainder of 2023. Bank officials pointed to concerns about a recession and withdrawals from deposits following the collapse of the SVB.
The largest banks with assets of at least 250 billion
“Medium sized compared to the largest banks [with between $50bn and $250bn in assets] and other banks more frequently cited concerns about their liquidity positions, deposit outflows and funding costs as reasons for tightening,” the Fed said in the survey.
In order to retain depositors, some banks have had to offer higher yields on savings accounts, which weighed on profit margins. Mid-sized banks, which faced the largest outflows of deposits, also raised concerns about tighter regulations and possible changes in accounting rules.
In terms of how a potential credit crunch could spread more broadly, the Fed’s Financial Stability Report said there was a risk of falling earnings and rising corporate defaults. “Furthermore, a related reduction in investor risk appetite could lead to a significant fall in asset prices.”
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The Fed also warned of weakness in the commercial real estate sector, saying “the magnitude of a correction in real estate values could be significant and therefore lead to credit losses for CRE debt holders.”
The central bank said it will also monitor developments in commercial real estate loans more closely and expand “screening procedures” for banks with a greater focus on the sector.
On the less worrying side, the Fed said, “shocks are less likely to propagate to the financial system via the household sector because household borrowing is modest relative to income and the bulk of household debt is owed by those with higher credit ratings.” .
Although the Fed warned that lending could suffer, the Fed said most banks seemed able to cope with tighter monetary policy.
“Despite the bank stress in March, high levels of capital and modest interest rate risk mean that a large majority of banks are resilient to potential stress from higher interest rates. As of the fourth quarter of 2022, banks were well capitalized overall, especially the globally systemically important US banks,” it said.
Additional reporting by Stephen Gandel in New York and Colby Smith in Washington