When banks face instability—as they are now after Silicon Valley Bank’s sudden downfall, as well as the failures of the crypto-focused Signature Bank and Switzerland’s Credit Suisse—they tend to become increasingly conservative. They’re more selective with loans, they often increase the interest rates on the loans they do offer, and they keep more cash on hand to protect themselves from a worst-case bank-run scenario.
These tighter lending standards can lead to a credit crunch that makes capital difficult to come by for consumers and businesses—and that can have a dramatic effect on the economy. Credit crunch fears have led to repeated predictions of an impending recession this month. But Goldman Sachs chief economist and head of global investment research Jan Hatzius believes that banks’ recent issues and an ongoing credit crunch may actually help the Federal Reserve cool the economy and fight inflation.
“Our baseline expectation is that reduced credit availability will prove to be a headwind that helps the Fed keep growth below potential…not a hurricane that pushes the economy into recession and forces the Fed to ease aggressively,” he wrote in a Tuesday note, referring to rapid interest rate cuts.
Fed officials have raised interest rates over the past year faster than during any other period in an attempt to quash inflation that reached a four-decade high of 9.1% last June. And like Hatzius, at a news conference last week, Fed Chair Jerome Powell made the case that stricter lending standards could have the same inflation-fighting effect that his rate hikes do.
As banks reduce the number of loans they offer, it makes it more difficult for businesses to invest in their growth and for consumers to find loans for new homes or cars, which effectively cools the economy. But there is a fine balance at play. If lending standards become too tight—just like if the Fed hikes rates too much—the economy can slow to the point where it sparks a recession.
But Hatzius doesn’t believe SVB’s recent issues will cause banks to reduce their lending to that degree, arguing that larger banks will continue to provide loans because they have “higher capital and liquidity standards than smaller banks and are subject to more stringent stress tests” from regulators, which makes them more resilient in times of financial stress.
The chief economist added that it is still too early to know the long-term implications from banks’ recent issues, however. And he now sees a 35% chance of a U.S. recession in the next 12 months, up from 25% last month, admitting that “the risks are clearly skewed toward larger negative effects” for the economy from SVB’s collapse.
Growing downside risks
Hatzius went on to outline two key risks to his baseline scenario on Tuesday: that recent U.S. bank instability is more like a “headwind” against economic growth than it is an outright recession-inducing “hurricane.”
First, he warned of the potential for another bank run due to consumer wariness after SVB’s collapse. “The most effective way to reduce this risk would be an unlimited deposit guarantee. But that probably requires an act of Congress, which is unlikely to materialize barring a more intense crisis,” he said.
Still, Treasury Secretary Yellen said last week that she will once again turn to the “systemic risk exception”—which enables the FDIC to cover deposits that exceed its current $250,000 insurance limit—to protect depositors in the event of another bank run.
“At least for now, this message seems to have helped,” Hatzius wrote, adding that data he has seen shows deposit outflows from U.S. banks have declined from their recent post-SVB collapse highs this past week.
The chief economist also argued the need to pay higher interest rates to attract depositors is a longer-term issue for banks in the age of social media and digital banking “where depositors can quickly move funds by just tapping an app.”
“[T]his is the first bout of turmoil of the truly digital age, in which residual concern about bank solvency may interact with frustration about low deposit rates,” he wrote. “This could put more significant upward pressure on bank funding costs and create greater downside risk to credit availability than our statistical analysis would suggest.”
