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The critical role of smaller banks in the economy means that distress increases the risk of recession

Main Street businesses and American households are likely to find it more difficult to get a loan because of the turmoil in the banking sector, which is slowing economic growth and increasing the risk of a recession.

“The risk in terms of SVB’s spark is real,” said Greg Daco, chief economist at EY-Parthenon, a strategy consulting arm of Ernst & Young LLP. The collapse of Silicon Valley Bank sparked fear among depositors leading to the bankruptcy of Signature Bank and the move to bail out First Republic Bank.

“Once there is stress in a certain set of institutions, those institutions and those who have agreements will tend to be more cautious about lending,” he said. “We will probably be in this state for an extended period of time.”

Smaller banks are crucial drivers of credit growth, the fuel that drives the economy. Banks smaller than the 25 largest banks account for about 38% of all outstanding loans, according to Federal Reserve data. They account for 67% of commercial real estate lending.

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Aggressive measures by the federal government and Wall Street to calm these fears are intended to prevent a wider crisis. But the possibility of other banks having similar problems has led to a sell-off in financial stocks as investors scrutinize banks’ solvency. This in turn caused public concern about the safety of deposits and the magnitude of unrealized losses.

Smaller banks are likely to respond by tightening standards and slowing lending to boost capital ratios, said Torsten Slok, chief economist at Apollo Global Management Inc., a private equity firm. He said those moves would brace against the risks of more fickle savers and volatile borrowing costs.

“If all of a sudden it’s much more difficult to get a car loan, a consumer loan, a commercial real estate mortgage, just because smaller regional banks have to reorganize balance sheets,” Slok said, “then you run the risk of a lot of people winning. ” I don’t get the financing to buy that car, to buy that washing machine, and those corporate loans take a hit.

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He expects the US economy to enter a recession by the middle of this year, caused by a decline in lending by smaller banks.

Until the bankruptcy of the SVB, Mr. Slok had expected a ‘no landing’ scenario, meaning that the economy would continue to grow despite signs of slowing down. “But add this risk to small and medium-sized banks, and we’re heading for a hard landing,” he said, or a painful downturn.

Silicon Valley Bank collapsed in less than two days. During that time, the stock price dropped by more than 60% and clients tried to withdraw $42 billion. Here’s how SVB became the second-biggest US bank failure ever and what it means for customers going forward. Illustration: Alexandra Larkin

Mr. Daco also said he believes the impact of the SVB has greatly increased the likelihood of a recession, and he expects one this year. Barring a financial meltdown, he expects tighter credit and financial conditions to shave about 0.5% of GDP over the next 18 months, keeping real gross domestic product growth broadly flat in 2023, with the fourth quarter compared to the same quarter in 2022. expanded by 0.9% in 2022 on the same basis.

Goldman Sachs economists raised the chance of the economy going into recession in the next 12 months to 35%, from 25% before the SVB collapse.

Regional and smaller banks are important to the overall economy, and certain corners depend even more on them for credit, said Bill Adams, chief economist at Comerica Bank, a major regional bank based in Dallas.

“The banks that fall outside the top dozen are more focused on banking services for small businesses and small towns and rural areas,” he said.

The turmoil in the financial system can tighten lending through various channels and ultimately weaken the economy. At a basic level, slumping equity and bond markets make financing investments more expensive. More directly, banks can try to repair their balance sheets faster than they otherwise would, says Daniil Manaenkov, an economic forecaster at the University of Michigan.

“That means you’re going to make less risky loans and when you do them, you widen your spreads,” he said. “Credit is getting a bit more expensive.” He added that some investment projects may be delayed, which could translate into fewer hires.

The first two months of the year, before the bank failures, saw strong recruitment. Job losses often lag the broader economy, as employers tend to cut jobs after taking other cost-cutting measures. The economy has been showing signs of slowing recently, including a drop in retail spending in February.

Banks had begun tightening lending standards late last year as the sharp rise in interest rates made it more difficult to find creditworthy borrowers and weakened demand for commercial loans, according to a Fed survey of senior credit officials.

The impact of the SVB is likely to exacerbate that tightening, which bodes badly for the labor market as it slows expansion and investment, said Padhraic Garvey, ING Bank’s regional head of research for the Americas.

“There’s a pretty strong correlation between credit standards and unemployment,” he said.

Write to Gwynn Guilford at [email protected]

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