As the dust starts to settle following the collapse of Silicon Valley Bank and Signature Bank in March, economists are warning of cracks in the system that started spreading even before the failures. Under conditions of banking turmoil, some are worried credit tightening will become a credit crunch.
“I’m getting really nervous now that an economy that I thought was going to dodge recession is now at much greater risk of falling into one and it could be quite severe because bank credit is the lifeblood for small businesses,” Pantheon Macroeconomics Chief Economist Ian Shepherdson said during a CNBC interview.
What is a credit crunch?
A credit crunch is a decline in lending activity driven by a shortage of funds. Or, as Moody’s Analytics Chief Economist Mark Zandi puts it, “the inability of households and businesses to get the credit that they need.” It’s a phenomenon that can have a big impact on the economy and its growth.
Following March’s Federal Open Markets Committee meeting, Federal Reserve Chair Jerome Powell said the second and third largest bank failures in U.S. history “are likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes.”
But the train was already on those tracks before the banks’ closures. Loan activity has been trending down due to the central bank’s aggressive actions to tame inflation. Over the last 12 months, the Fed raised its benchmark interest rate from near 0% to nearly 5%.
The latest Fed survey found roughly 44% of banks reported tightening standards for business loans in the first quarter of 2023. With the exception of the COVID-19 pandemic, it’s the highest share to say that since 2009 in the wake of the Great Recession.
“The possibility of the restriction of credit to be so significant that under almost any terms you can’t get a loan, that’s certainly a risk of something that may happen,” Zandi told Reuters.
The most recent example of a credit crunch was after the 2008 financial crash. Financial institutions had trillions of dollars in subprime mortgages that were essentially worthless. Banks that were able to weather the storm didn’t have the resources or risk appetite to lend at their previous pace. Even highly-qualified individuals and businesses struggled to get approved.
Access to capital fuels growth in the U.S. economy and that credit crunch significantly slowed expansion in the years that followed.
“The ‘08, ‘09 financial crisis is in a league of its own,” Zandi said. “What we’re experiencing now, it doesn’t feel very good, it’s very uncomfortable, but it’s nothing compared to what we suffered back in that crisis.”
The Federal Reserve is monitoring how commercial banks tightening credit will affect its policies moving forward.
“The key is we have to have policies to bring inflation down to 2% over time,” Powell said in March. “It doesn’t all have to come from rate hikes. It can come from tighter credit conditions.”
Reaching the Fed’s 2% inflation target without entering a recession, known as a soft landing, was already a challenge with the central bank’s limited, blunt toolset. But at least the Fed has control over those tools. A credit crunch could bring in a whole new set of unknowns.
“I’m much less confident in my optimism about avoiding recession than I was two weeks ago because of the banking crisis,” Zandi said. “There’s a lot of uncertainty here. How significant is this credit crunch going to be? How big an impact is that going to have?”
Small business could struggle to secure its ‘lifeblood,’ bank credit
As we now know, banks were already reporting tighter credit conditions even before the banking turmoil that began in March. But smaller banks are now getting hit twice as hard as customers move deposits away from regional institutions, which could put some small businesses in further peril.
In the week following Silicon Valley Bank’s troubles, customers made a record number of withdrawals from smaller banks, feeling more confident that bigger banks would be a safer place for uninsured deposits after the second and third largest bank failures in U.S. history.
The latest Federal Reserve data shows between March 8 and March 15, the top 25 banks in the country gained $120.2 billion in deposits, while all of the other banks in the country lost $184.6 billion. In the week that followed, smaller banks failed to gain any of the deposits back, losing another billion by March 22.
“And you have bank management thinking, ‘Ok, how do we survive this now? Well, we probably don’t do it by lending,’” Shepherdson said.
Banks use deposits to fund loans, so all of the banks that lost deposits are likely to tighten credit even more in the aftermath. Small and medium-sized businesses are disproportionately impacted by this. According to UBS research, smaller and regional banks hold 40% of these companies’ loans and debt.
“Bank credit is the lifeblood of small businesses and most people work for small businesses, they drive a huge amount of economic activity and they’re really gonna struggle,” Shepherdson said.
According to Pantheon Macroeconomics research, small and medium-sized companies employ 58% of private workforce in the U.S.
Small business bankruptcy filings already on the rise pre-banking crisis
On Tuesday, April 4, Richard Branson’s satellite-launching company Virgin Orbit filed for Chapter 11 bankruptcy. When a public company like Virgin Orbit goes bankrupt, there is no shortage of headlines. But there’s an undercurrent happening in the bankruptcy world that isn’t getting as much attention.
This year, research shows private companies are filing for bankruptcy at rates that exceed what was seen at the height of the pandemic. According to UBS, a lot of bankruptcies are at smaller firms for now, so the impact on assets and employees is not as egregious as the sheer number of filings.
Experts say real estate is one place that is seeing a bankruptcy boom, while health care, retail, construction, restaurant and financial sectors are areas to watch.
Former bankruptcy judge and current American Bankruptcy Institute President Kevin Carey said he’s witnessed bankruptcy filings ticking up for the past couple of months.
“We’ve been talking about, for a really long period of time now, for the recession to happen,” Carey told Straight Arrow News. “And so a lot of the lending is on hold. Investors don’t want to put money into a volatile economy.”
Carey said the banking crisis is just injecting more uncertainty into an economy that was already tightening credit. The latest Fed survey found roughly 44% of banks reported tightening standards for business loans in the first quarter of 2023. With the exception of the COVID-19 pandemic, it’s the highest share to say that since 2009 in the wake of the Great Recession.
“Once liquidity runs out, companies are faced with very few choices,” he said, noting that many Chapter 11 bankruptcies he’s seeing now are seeking a sale of the business as opposed to restructuring. “So many businesses that find their way into Chapter 11 are over-levered, and businesses find themselves in a situation in which there’s just no way out but to sell the company.”
SVB paid bonuses hours before collapse. Politicians are looking for authority to claw that back.
Mere hours before the federal government seized it, Silicon Valley Bank paid out employee bonuses. In response, a bipartisan group of lawmakers have introduced legislation to recoup funds from bank executives in the event of future failures.
While the timing appeared suspicious, the SVB bonuses were a part of employees’ annual payout and planned in advance of the bank’s collapse. But paired with CEO Greg Becker cashing out $3.6 million in shares of SVB less than two weeks prior to the failure, these actions caught the attention of Washington politicians.
“It’s outrageous that these people took bonuses and sold stock in the days leading up to the bank’s failure,” Sen. Kyrsten Sinema, I-Ariz., said during a banking committee hearing featuring regulators on March 28. “We should hold these executives accountable for the fullest extent of the law and claw back those bonuses and stock sales.”
Federal regulators immediately terminated bank leadership in the wake of the collapse, but they had a cushion to fall back on. Executives and directors at SVB cashed $84 million worth of SVB stock over the past two years as the bank’s profits soared, according to Smart Insider. That’s in addition to the millions paid in executive salaries each year.
“When banks fail because of mismanagement and excessive risk taking, it should be easier for regulators to claw back compensation from executives, to impose civil penalties, and to ban executives from working in the banking industry again,” the White House said in a statement a week after SVB failed.
In various forms, Congress has answered the call. A bipartisan group of senators headlined by Sen. Elizabeth Warren, D-Mass., introduced “The Failed Bank Executives Clawback Act of 2023” on March 29. The bill would “claw back from bank executives all or part of the compensation they received over the five-year period preceding a bank’s insolvency or FDIC-resolution.” Republican Sens. Josh Hawley, R-Mo., and Mike Braun, R-Ind., are also co-sponsors.
Warren said the legislation would incentivize executives to act more cautiously.
“If you load this bank up on risk and the bank explodes, you’re going to lose that fancy bonus, you’re going to lose that big salary, you’re going to lose those stock options,” Warren said in an interview with CNBC on Friday, March 31.
Michael Barr, vice chair of supervision at the Federal Reserve, told senators during the week of March 26 that regulators already have some authority to hold executives accountable. He said the consequences could include a prohibition from banking, civil penalties or payment as part of restitution.
Saving depositors from SVB’s failure cost the Federal Deposit Insurance Corporation’s deposit insurance fund $20 billion. The fund will eventually be replenished through a special fee on banks. FDIC Chair Martin Gruenberg told the Senate Banking Committee that giving the FDIC explicit clawback authority “probably would have some value.”
Separate but similar legislation has been introduced in the House of Representatives as well. Despite the bipartisanship in introducing these types of bills, Congress has struggled to cross this finish line in the past.
Following the 2008 financial crisis, the House passed a bill by the wide margin of 328 to 93 that would have imposed a heavy tax on bonuses of high-earning employees at companies that were bailed out by the federal government. The legislation later stalled in the Senate.
Banking crisis ‘hiding in plain sight,’ this leading bank CEO says
The CEO of the largest bank in the U.S. is warning the government to avoid “knee-jerk, whack-a-mole or politically motivated responses,” to the latest bank failures. JPMorgan Chase leader Jamie Dimon has been meeting behind the scenes with regulators and other bank leaders over the past month but commented publicly on the banking crisis for the first time on Tuesday, April 4.
In his annual letter to shareholders, Dimon said the latest banking risks that led to the collapse of Silicon Valley Bank and Signature Bank were, “hiding in plain sight.”
“This wasn’t the finest hour for many players,” he wrote, saying that while it doesn’t absolve Silicon Valley Bank management, the Federal Reserve also made mistakes. Dimon criticized the Fed’s current model to stress test banks, noting that they never incorporated the risk of rising interest rates.
Silicon Valley Bank found itself in trouble after failing to hedge interest-rate risk when buying bonds. Over the past year, the Federal Reserve raised its interest rate from near-zero to nearly 5%, and SVB’s low-interest bearing, long-term securities lost market value.
In a notice that ended up triggering a devastating bank run, SVB management announced they were raising capital and had sold $21 billion in bonds at a $1.8 billion loss. The next day, customers attempted to withdraw 20% of the bank’s total deposits, causing the bank to collapse.
Signature Bank customers followed suit, with federal regulators taking control of both banks. Other regional banks wobbled in the aftermath of the collapse as customers pulled funds out of smaller banks, worried they could face a similar fate. Dimon led efforts to stabilize First Republic Bank from collapse, which included pooling together a $30 billion lifeline to the bank.
“The current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come,” Dimon said. “But importantly, recent events are nothing like what occurred during the 2008 financial crisis.”
As politicians push out legislative proposals based on the banking turmoil, Dimon warned that the debate should not always be divided between more or less regulation, but about the right mix of regulations that, “will keep America’s banking system the best in the world.”
The banking upheaval did not stay within U.S. borders following the bank collapses. Switzerland’s Credit Suisse also fell in the aftermath, with the government orchestrating a buyout by the country’s largest bank, UBS Group. Meanwhile, First Citizens Bank scooped up SVB and its deposits at a $16.5 billion discount.
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