The banking turmoil in March sparked fears of a looming credit crunch and a repeat of the 2008 financial crisis. While there was no unique driver to the bank failures, there were at least four catalysts: rising interest rates impacting held-to-maturity assets, a concentration of lending to (mostly tech) startups backed by venture capital funds, exposure to the crypto markets, and a concentration of interest-only real estate loans to high-net-worth individuals. But one common thread stood out: limited risk hedging.
The banking situation is currently much less dire than feared thanks to a swift policy response by the Federal Reserve, Treasury and Federal Deposit Insurance Corporation (FDIC) to reassure depositors and provide liquidity to the banking system, including via the Bank Term Funding Program (BTFP).
We estimate that the cumulative tightening in credit conditions in the wake of recent banking sector stress will represent a drag on the US economy worth around 0.4% of GDP over the next year. Yet, there remains a risk of further stress affecting the banking sector. Indeed, there were still $102b in outstanding loans via the BTFP in mid-June – a sign of lingering pressure on banks’ balance sheets.
Given the downside risks to the outlook, we have modeled an alternative scenario to assess the economic impact of a more pronounced "credit crunch." In this scenario, elevated economic and financial market uncertainty along with central banks favoring tighter monetary policy stances in the face of persistent inflation exacerbate the stress in the banking sector. Ongoing softness in the residential real estate sector and worsening conditions in commercial real estate (CRE) activity exacerbate banking sector woes.
As banks prioritize shoring up their balance sheets, credit conditions for US businesses and households tighten abruptly by a magnitude equivalent to a third of the credit tightening seen during the global financial crisis.
At the same time, household and business finances deteriorate with rising delinquencies and defaults putting additional pressure on lending institutions, leading to more banking failures and generating a further tightening of credit conditions. Small and mid-sized regional banks suffer the brunt of the correction which affects small and medium-sized businesses with a disproportionate reliance on credit.
The turbulences lead to a sharp decline in private-sector confidence and trigger severe financial market turmoil along with widespread deposit flights to larger banks and money market funds. Stock prices plunge, and credit spreads for corporate bonds and credit default swaps rise significantly.
The CRE market is hit particularly hard given the pre-existing headwinds and because regional banks have a disproportionately high exposure to real estate, accounting for two-thirds of all CRE bank lending. Downward pressure on CRE assets further exacerbates the banking sector and financial market stress.
The consumer, tech, real estate and manufacturing sectors are also impacted severely in this credit crunch given their exposure to credit. But the reality is one where no sector is spared given the level of banking sector and financial market stress.
The consequence for the economy is dire with consumer spending and residential and business investment retrenching. Real GDP growth falls 1.7% below our baseline by the end of 2024, with growth averaging -0.3% in 2024 compared with 0.7% in our current baseline. The unemployment rate rises 1ppt above our current forecast, to 5.5% by Q4 2024. And headline CPI inflation is 0.9ppt lower at around 2% by Q4 2023.
The US banking sector crisis leads to severe global financial market stress and a tightening of credit conditions across the world economy. Market volatility spikes, global stock markets plummet, and global investment-grade and speculative-grade bond spreads widen sharply. Private-sector activity among advanced economies is the most affected. Overall, world GDP growth falls 0.4ppt below our baseline, to 2.4% in 2024.
