A potential credit crunch among smaller US lenders in the wake of recent bank failures would likely limit how high the Federal Reserve will raise interest rates this year.
Depositors broadly fled to bigger banks, perceived as safer, following a run on tech lender Silicon Valley Bank and the ensuing turmoil that also engulfed Signature Bank. Deposits at small banks — those with less than $250 billion in assets — fell by $120 billion to $5.456 trillion between March 8 and March 15, while deposits at large banks grew by nearly $107 billion to $10.740 trillion, according to the latest data from the Fed.
Those smaller banks are key pillars of business and consumer credit, though their ability to lend will be limited by concerns around the prevalence of uninsured deposits and the possibility of further deposit flight, according to economists. This reduction in credit availability for households and businesses would tighten broader financial conditions and could be equivalent to one or more Fed rate hikes, according to Chris Varvares, co-head of US Economics at S&P Global Market Intelligence.
"If it looks like the bank credit expansion is really being pulled back on, then that could substitute for Fed tightening," Varvares said. "Financial conditions are tightening. That is what the Fed wants to happen."
GDP hit by credit reduction
Small commercial banks accounted for 57.3% of the $2.752 trillion in mortgage loans and 45.2% of the $2.071 trillion in consumer loans in 2022, according to data from S&P Global Market Intelligence.
The prospect of restrained lending is bad news for the US economy but good news for the Fed's strategy to squeeze inflation by reducing the availability of credit. A tightening in lending could knock off as much as 0.5% of GDP, according to Varvares. Market Intelligence's most recent forecast for US growth in 2023 was just 1%, down from 2.1% in 2022.
"There's likely to be less credit expansion as a result of this, banks are going to be a bit stingier, they'll want to see their loans-to-deposit ratio decline and have more cash on hand," Varvares said.
Meanwhile, Goldman Sachs estimates a decline in GDP of 0.25%-0.5%, which would equate to additional Fed rate hikes of between 25 basis points and 50 basis points. Since March 2022, the central bank has raised rates from a near-0% floor to a range of 4.75%-5%.
Bank stocks tanked in the wake of the bank failures as investors feared contagion of depositor withdrawals, with those banks most exposed to uninsured deposits — and therefore not backstopped by the Federal Deposit Insurance Corp. — hit the hardest.
The S&P Regional Banks Select Industry Index, which tracks a basket of 144 smaller US banks, fell nearly 28% from March 1 to March 27. Prior to its collapse, Silicon Valley Bank was the largest bank in the index by market capitalization.
Facilities to offer banks liquidity and a commitment by Treasury Secretary Janet Yellen to insure deposits at banks if they fall into trouble have taken the sting out of the banking panic. Yet the damage could have already been done for a crucial sector of the economy, and the Fed is now closer to its terminal rate as tighter credit conditions will squeeze small and midsize enterprises, according to investment management firm PIMCO.
"The stress in the banking sector will work to slow economic activity, demand, and eventually inflation, resulting in the Fed needing to do less to sufficiently tighten financial conditions," said Tiffany Wilding, North American economist at PIMCO.
The Fed proceeded with a quarter-point rate hike at its March meeting, and Chair Jerome Powell emphasized in the post-meeting press conference that the Fed's dual mandate of maximum employment and price stability remains its primary objective, while acknowledging the potential impact of the bank failures.
"Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation," the rate-setting Federal Open Markets Committee noted in its March 22 statement.
In addition to loans to households, smaller banks are also major lenders to the residential and commercial real estate sectors. As a result, the stresses in the banking system have increased the prospect of a hard landing for the US economy, according to Anna Stupnytska, global economist at Fidelity International.
"The current market stress, a symptom of the size and speed of policy tightening to date, is feeding wider spillovers through the bank lending channel to the real economy," Stupnytska said.