Bankers are bracing for a deterioration in credit quality and increased liquidity pressures in the wake of a sharp escalation in interest rates and an impending economic downturn. Portents of economic pain include a deeply inverted yield curve, underwater bond portfolios, a rise in corporate defaults and liquidity-driven bank failures.
Has the industry done enough to prepare? While the answer to this question ultimately depends on the level of future rate increases, when viewed from today's vantage point, the industry appears to be well situated to weather the anticipated downturn.
Signs of an economic slowdown are unmistakable. Economic activity in the manufacturing sector declined in December, as did consumer spending. GDP growth in the fourth quarter, while better than what economists expected, also declined from the prior quarter and exhibited some underlying weaknesses including a slowdown in capital spending. According to the Federal Reserve's Beige Book, economic activity in many regions of the country was tepid and bankers reported a decline in loan demand. It's not surprising that most economists, business leaders and bankers expect the economy will undergo a mild recession.
Yet, by other measures the economy remains resilient. The labor market remains robust. Employers added 517,000 jobs in January and the unemployment rate fell to 3.4%, the lowest in more than 53 years. The number of job vacancies still exceeds the number of people looking for work and recently announced layoffs have been concentrated in certain sectors such as technology.
Furthermore, economic activity expanded in the service sector. Inflation, while still high, is declining and supply chain challenges have eased somewhat. So, economic signals are quite mixed. While credit conditions are expected to soften over the next six months, economic activity remains strong enough that a recession is far from certain.
This doesn't mean that concerns about increased liquidity risk and a deterioration in credit quality are not warranted. On the contrary, the recent bank failures reinforce the importance of diversity in funding sources and there is a general consensus that credit quality will deteriorate across all loan types. For example, delinquency rates on consumer loans have been slowly increasing and there are worries that consumers are now maintaining their spending through increased borrowing. There are also heightened concerns about nonowner occupied commercial real estate loans, which have been a major area of growth in the last few years.
The widespread adoption of remote work poses an ongoing risk to the office sector, and the rapid increase in interest rates and inflation have given rise to concerns about elevated financial stress on borrowers in other sectors including construction and land development, nonfarm nonresidential loans, and multifamily properties.
Yet, the strong financial position of the industry should enable it to handle a deterioration in credit quality arising from a mild recession. For example, banks across all asset tiers have significantly increased their regulatory capital levels and loan loss reserve coverage ratios compared to what they were immediately prior to the onset of the Great Recession. The increase was partly driven by loan growth, but it also reflects conservative assumptions regarding the economic outlook.
The increase in reserves has been undertaken even as credit quality remains excellent. Delinquency rates of 30 days or more past due continued to decline through the third quarter of last year. While net charge-offs ticked up slightly to 0.26%, they remained well below the prepandemic, five-year average of 0.47%; therefore, the rate of net charge-offs could almost double before reaching a normalized level. Credit quality remained excellent in the fourth quarter and executives reported minimal stress among their loan customers. That will undoubtedly change as borrowers begin to feel the full impact of substantially higher rates and reduced demand, but the increase will be off of a historically low level.
In addition to building reserves, bankers began tightening underwriting standards for most loan categories in the second quarter of last year and that process has continued. Covenants were also further tightened on commercial-and-industrial loans and higher premiums were charged for riskier borrowers, and minimum credit scores were again raised on new credit cards and auto loan applicants. Importantly, this tightening has been undertaken in advance of any significant deterioration in credit quality.
Recent steps by the regulatory agencies, including protecting uninsured customer deposits at SVB and Signature Bank and the Federal Reserve's creation of a lending facility which will allow banks to exchange certain high-quality assets for cash without booking mark-to-market losses will help to ameliorate liquidity risk.
Yes, banks must continue to be vigilant, but bankers are in the business of managing and pricing for risk, in both good times and challenging times. Assuming they have a risk rating framework of sufficient granularity, solid underwriting standards, rigorous portfolio stress testing, and meaningful portfolio reporting, banks should be well situated to assess, monitor, manage and price for credit and liquidity risk during challenging times. Banks must continue to serve existing customers, and if banks curtail lending for too long, they risk losing business.
