US credit crunch didn't start with SVB collapse

It wasn’t the March 10 collapse of Silicon Valley Bank that prompted Carissa Rodeheaver, head of a community bank tucked in the mountains of western Maryland, to rethink strategy.

That process started last year when Federal Reserve interest rate hikes and a less certain economic environment caused Rodeheaver, the CEO of the $1.9 billion First United Bank & Trust in Oakland, Maryland, to shift focus from commercial real estate lending, begin “husbanding deposits” with a tougher look at the collateral backing loans, and end up with only a slight, $9.6 million increase in lending over the first three months of 2023.

“When you get into higher interest rates … you look to your collateral,” Rodeheaver said in an interview. “We are tightening on price and profitability … That is going to slow lending a bit.”

In assessing the impact of the aggressive rate hikes that have lifted the Fed’s benchmark overnight interest rate a full 5 percentage points over 14 months, U.S. central bank officials may take some solace from First United’s experience that the worst sort of credit shock has been avoided despite the dramatic collapses two months ago of SVB and Signature Bank and the more recent failure of First Republic Bank.

First United did see deposits leave early in the first quarter of this year as some account holders spent down balances and others sought higher interest rates, but padded its cash with brokered deposits and “strategic” borrowing from the Federal Home Loan Bank system, according to the company’s results for the quarter.

Yet if lending increased only slightly, increase it did. For Fed officials, that could spell the difference between concerns about an economy-wrecking credit crash, and the sort of restraint policymakers would not only expect as they raise rates, but need to take root for inflation to slow.

‘PART OF THE TRANSMISSION’

A Fed report on financial stability and a central bank survey of bank loan officers this week reinforced that the banking system wasn’t on the brink of a broad crisis but was making credit less available and more expensive, a process that should mean less consumer and business spending and, eventually, lower inflation.

“Data showing that banks have started to raise lending standards … is typical for where we are in the economic cycle,” Fed Governor Philip Jefferson said on Tuesday. “The economy has started to slow in an orderly fashion” in response to higher interest rates, Jefferson said, calling tighter credit conditions “part of the transmission mechanism of monetary policy.”

After the Fed raised its policy rate to the 5.00%-5.25% range at a meeting last week, debate shifted to whether policymakers would find that level adequate to control inflation, allowing them to pause the tightening cycle, or whether further increases might prove necessary.

One focus is whether the banking sector, rattled by the failures of the three regional lenders and facing the fastest rate increases since the 1980s, would crack down so hard on lending that the economy spun into a recession.

According to the minutes of the Fed’s March 21-22 meeting, central bank staff at least saw “the potential economic effects of the recent banking-sector developments” as sufficient to shift the outlook from “subdued growth” to a “mild recession” later this year. Fed Chair Jerome Powell said that staff forecast was reiterated at last week’s meeting.

Powell, however, said he felt the impact of the credit shock “remains uncertain,” and his own baseline outlook does not include a recession.

Recent data and survey responses also have pointed away from the harshest outcomes. Bank lending dipped about 1.7% in the two weeks following SVB’s collapse, but has risen since then and recouped about a third of the decline.

The Fed’s Senior Loan Officer Opinion Survey, which was conducted after the collapse of SVB and released on Monday, was less dire than anticipated: Only a slightly larger share of banks tightened standards for key business loans compared with the survey in January. The Fed’s semi-annual financial stability report, also released on Monday, saw scant evidence of a broad crisis developing.

Investors responded by boosting bets that the Fed will end up raising rates at its next meeting in June, though they continue to give more than an 80% probability that it will hold rates at the current level.

Analysts say the loan officers survey may be less important for what it says about the current state of credit after the SVB collapse than for what it shows may unfold in response to a weakening economy – a dynamic that seems to be affecting loan demand as well as the potential supply.

In response to special questions tailored to the current climate, loan officers saw continued credit tightening through this year, particularly for commercial real estate loans, and declining demand for a broad swath of lending.

The most recent sentiment survey from the National Federation of Independent Business buttressed that view, with the share of firms planning capital outlays in the next three to six months dipping to what NFIB characterized as a “historically weak” 19% in April. The overall index fell to more than a 10-year-low.

The Fed loan officers survey showed a general wariness about the economy, with respondents saying their plans to tighten credit revolved around risk version and concerns about the value of collateral more than from problems with their own capital or liquidity positions – the sort of issues that might flag broader financial stress.

“There is a threat of recession and obviously we see that, we are planning for it,” said Greg Hayes, president and chief operating officer of Kish Bank in central Pennsylvania. “The question is will the Fed back off at the right time or overshoot?”

Ramon Looby, president and CEO of the Maryland Bankers Association, said Fed rate hikes have posed challenges, with some of the drop in loan demand, he suspects, because higher borrowing costs “might be pricing folks out and having them wait on projects.”

But banks “are still making deals,” Looby said. “The Fed and Chair Powell have made it tremendously clear that the goal is to tame inflation, and they will do it by tightening financial conditions … How the industry responds – folks are going to be paying much more attention to liquidity and then being judicious.”