Tracking the Fallout from Bank Stress
With the risks of imminent bank failures fading, markets have settled down, but that doesn’t mean the economy is off scot-free. Here’s what to look for to track the situation and its impact on the U.S. economy.
Is the stress getting better or worse?
Bank deposits: Bank deposits have been shrinking for the past year, as Fed tightening spurred a flight to money-market funds and households depleted some pandemic savings. But the decline accelerated after the failure of three regional banks in early March. Deposits of domestically chartered banks shrank by $384 billion (or 2.4%) in the four weeks to March 29. This was partly due to the closure of the three banks. Clients also shifted some deposits from smaller lenders to institutions deemed too-big-to-fail. However, both small and large banks reported an upturn in deposits in the week of April 5, implying stability. Moreover, deposits remain about $4 trillion (or 30%) higher than at the start of the pandemic, meaning the banking system remains flush with liquidity.
Bank loans: To date, the drop in deposits has not led to a material pullback in credit. Bank loans fell just $34 billion (or 0.3%) in the first four weeks of the turmoil, before turning up more recently, including at smaller lenders. The decline in credit was directed at businesses rather than consumers and homeowners. Total loans are still up $900 billion (or 9%) in the past year.
Fed support: Federal Reserve loans to banks shot up $303 billion in the first week of the turmoil and by an additional $36 billion in the following week. Banks borrowed from the discount window and the new Bank Term Funding Program. The emergency aid was rivaled only in the Great Recession. However, the Fed’s credit to banks fell by $29 billion in the four weeks to April 19, suggesting the stresses in the banking system are stabilizing.
Share prices: The S&P Banks index dove 18% initially, before recovering about a third of its losses on the quick response by policymakers to prevent contagion and some better-than-expected Q1 bank results. However, investors remain wary, as the sector lags a moderate gain in the Composite Index. This nervousness is captured in the Cleveland Fed’s Systemic Risk Indicator, a daily measure of investor perceptions of default risk. It showed a large increase in insolvency risk to mid-March, though it has since retraced about half of the rise, and remains well below the peaks reached in the financial crisis and pandemic shutdowns.
Is the fallout getting better or worse?
Confidence: The banking stress has had limited effect on sentiment. Small business confidence sagged a bit in March, while two consumer sentiment indexes were mixed. The Conference Board’s measure surprisingly turned up in March, though the University of Michigan’s index fell sharply before steadying in April.
Financial conditions: Financial stress is never good for markets. But equity prices are moderately higher and long-term Treasury yields lower than at the start of the turmoil. While the Chicago Fed’s National Financial Conditions Index weakened slightly to April 14, conditions remain better than normal and much stronger than in past crises. Similarly, the Office of Financial Research’s Financial Stress Index, after an initial spike higher, has slipped below normal levels. The St. Louis Fed’s Financial Stress Index also tells a similar tale of stability. The upshot is that stress in the banking system has had little effect on financial conditions.
Cost of credit: Corporate credit costs were little changed by the bank failures. Ten-year triple-B spreads versus Treasury yields initially widened modestly, but have fully retraced the increase. At 1.7 ppts, the gap pales against the near 5 ppt gulf reached in the pandemic and the 7 ppt chasm in the financial crisis.
Availability of credit: Stable credit costs are cold comfort if you can’t get a loan. Rising deposit rates have increased bank funding costs and pressured lending margins, reducing the incentive to lend. Small businesses are feeling the pinch, as loan availability fell in March to the lowest level since at least 2018. The Dallas Fed’s Banking Conditions Survey also reported stricter lending standards in the region. On May 8, the Fed’s quarterly Senior Loan Officer Survey will likely report a fourth consecutive quarter of tightening loan standards, as the Beige Book found that banks in several Districts (notably San Francisco) tightened their loan standards due to “increased uncertainty and concerns about liquidity”, resulting in a general decline in loan volumes. Of the many ways that banking stress can hurt the economy, restricted access to credit is the most concerning. Smaller banks will likely feel the most pressure to scale back lending, pinching smaller businesses, rural regions, and the commercial real estate sector.
Bottom Line: Barring further trouble, the economic impact of the bank failures could be muted, meaning the most anticipated recession in history might get another reprieve. Still, tighter lending conditions will only compound the lagged effect of tighter monetary policy, keeping a downturn on the table.