Photo illustration: Intelligencer; Photo: Getty Images
Nearly three weeks ago, the FDIC and the Federal Reserve took extraordinary measures to contain the fallout from the collapse of Silicon Valley Bank. These efforts saved SVB’s depositors from the threat of bankruptcy and prevented a domino rally of catastrophic bank runs. However, the SVB crisis is still weighing on America’s small and regional banks, increasing the risk of a near-term recession in the process.
The main problem facing such banks is simple: when the Federal Reserve raises interest rates, the return on money held in a money market savings account rises. Banks can respond to this reality by raising the interest rate on their savings accounts to a level that is competitive with the money markets. But that would dramatically increase their funding costs. And since ordinary depositors don’t usually pay that much attention to whether their bank pays a competitive interest rate, banks usually feel little pressure to do so.
But the collapse of SVB changed that. Although the government bailed out the bank’s depositors (and those with less than $250,000 in their accounts were never at risk of losing money), days of national news coverage focused on the prospect of businesses being wiped out because keep your money in a bank that was theoretically “small enough to fail” has caused many Americans to reexamine their own banking practices. At the same time, as frightened investors sold off the shares of regional banks, depositors in these institutions began to worry about the safety of their money.
This national bout of financial self-reflection has led many households to realize that they can secure a higher return on their savings—at about the same risk—by moving their bank deposits into a money market savings account. Meanwhile, the most paranoid depositors in small and regional banks have decided to shift their savings to the books of Wall Street’s megabanks, which face less risk of bankruptcy and a greater likelihood of being bailed out in the event of a disaster.
As a result, after the collapse of SVB, America’s 25 largest banks gained $120 billion in deposits, while smaller lenders drained $108 billion from their accounts. Meanwhile, assets held in money market funds hit a record $5.2 trillion this month as savers added more than $300 billion to them over the past three weeks.
This has adverse consequences for American economic growth because savings held in money markets contribute less to investment and consumption than those held in banks. Currently, nearly $2.3 trillion of all money market funds are parked in the Federal Reserve’s reverse repo facility, where they are effectively taken out of circulation. Barring a change in Fed policy, more money is likely to flow into this lucrative niche on the sidelines of the economy, as the reverse repo facility offers a nearly risk-free 4.8 percent annual return on cash.
This leaves small and regional banks with fewer options to provide capital to borrowers. With less money on their balance sheets and depositors already on edge, such lenders are bound to become more risk-averse and tighten credit standards. Which has big implications for the wider economy. Smaller banks have increased lending more than Wall Street titans since 2000, providing 38 percent of all outstanding loans.
Moreover, mid-sized banks are particularly important players in the commercial real estate industry, providing 67 percent of all loans to this sector. This is not ideal for both office builders and smaller banks, as the former were already facing serious economic difficulties even before their main lenders began to tighten access to credit.
U.S. office occupancy rates remained at roughly 50 percent of their pre-pandemic levels as of late January. These vacancies have already started to weigh on employment in the commercial real estate sector, even before SVB’s banking. As Preston Mui and Alex Williams of the Employ America think tank note, hiring in the construction services industry — that is, for roles such as “janitors, landscapers, security guards, office clerks and freight workers” — has been stagnant since the month.
As commercial real estate firms see their borrowing costs rise, stagnant hiring in the sector could give way to net job losses.
For their part, many mid-sized banks were already nervous about their exposure to commercial real estate before this month. Last year, a report by Moody’s Investors Service found that 27 regional banks have a high concentration of commercial real estate loans on their balance sheets, holdings that could prove problematic in the event of a recession.
The combination of commercial real estate developers and managers fretting about telecommuting and more expensive credit — and banks jittery about their exposure to the industry — threaten to reinforce each other in a vicious cycle: As banks raise lending costs or withdraw support , commercial real estate firms could become financially weaker, prompting banks to further withdraw support.
In addition to the particular risks to commercial real estate, risk-averse small and medium-sized banks can make lending more difficult and expensive to secure throughout the economy, causing businesses to abandon planned investments and consumers to cut back on debt-financed spending.
For one thing, pulling back on loan-fueled consumption and investment is exactly what the Federal Reserve is trying to create. The central bank’s interest rate hike was intended to slow spending across the economy so as to reduce inflation. But there is a significant difference, at least in theory, between gradually reducing access to credit through predictable increases in benchmark interest rates and suddenly a collapse in credit availability.
“If it suddenly becomes much more difficult to get a car loan, a consumer loan, a commercial real estate mortgage, simply because the smaller regional banks have to restructure their balance sheets,” said Torsten Slok, chief economist at private equity firm Apollo Global Management, recently on Wall Street Journal, “then you run the risk of a lot of people not getting the financing to buy that car, to buy that washing machine, and corporate lending taking a hit.” Before the SVB collapse, Slok expected the U.S. economy to avoid a recession this year. He now believes he is heading for a “painful decline”.
However, if a recession has become more likely in the near term, it is far from certain. The U.S. labor market remains about as strong as it has been in decades, with employers adding 311,000 jobs in February. As employment increases, so do total income and spending levels. In February, personal income rose by 0.3% and expenses by 0.2%. Over the past two years, American households have been able to maintain their spending in the face of rising prices thanks to the record savings they accumulated during the pandemic. In recent months, it appeared that such savings would soon be exhausted. But as incomes rose in February, households began to rebuild their cash reserves as the savings rate reached 4.6 percent, up from 3 percent last fall.
However, there is usually a difference between the start of an economic slowdown and mass job losses, as firms usually look to cut other costs before cutting wages. And there is some signs that the labor market may be weakening. New jobless claims rose modestly last week, even as the rate of workers quitting fell sharply. The latter is a decent barometer of the strength of the labor market, as workers are much more likely to voluntarily leave their positions if they either have a job offer from another employer or the perception that job opportunities are plentiful.
For now, many analysts see the U.S. as still likely to avoid a recession this year, with Goldman Sachs economists putting the odds of a recession in 2023 at 35 percent, down from 25 percent before the SVB collapse. But investors are betting that deteriorating economic conditions will force the Fed to incision interest rates as early as this fall.
In short, although federal intervention has dramatically reduced the cost of Silicon Valley Bank’s mismanagement, its full cost may still be high.