In wake of failures, bank economists expect weaker credit quality, lighter lending

Victor J. Blue/Bloomberg

Credit conditions are bound to weaken in the second quarter and beyond as the economy slows and fallout from the recent banking crisis washes over the industry.

That's according to the American Bankers Association's latest Credit Conditions Index, released in April that covers forecasts for the next six months. If expectations are realized, it would mark a stark shift from 2022, a year in which banks grew lending at a steady clip while maintaining historically low credit losses.

"Recent strong credit quality will be challenged by heightened uncertainty and broader economic headwinds this year," said ABA Chief Economist Sayee Srinivasan in an email. "Lenders are responding with cautious and prudent underwriting."

The ABA's credit index produced a reading of 5.8, a steep drop from the already anemic 12.5 result posted in a January report. A sub-50 reading indicates that the economists expect credit market conditions to deteriorate. The results are based on a survey of chief economists at 15 of the nation's biggest banks.

The latest reading is the weakest since the height of the pandemic in 2020.

At issue is the convergence of multiple forces that threaten the economy and, by extension, banks' ability to lend without heightened exposure to losses.

The Federal Reserve has hiked interest rates several times over the past year in an effort to tame inflation that soared to the highest level in decades following supply chain disruptions caused by the pandemic. When rates rise rapidly, borrowing costs increase and loan defaults tend to follow.  

Inflation in 2022 peaked at 9.1%. It finished the year at 6.5% and has since ticked lower to 6%. Still, it is three times the level that Fed officials say is healthy for the economy. The combination of high rates and festering inflation historically has tilted the economy into recession.

Then, in March, the failures of Silicon Valley Bank in California and Signature Bank in New York amplified worries about industry weakness.

The sudden demise of the two banks — coupled with the self-liquidation of Silvergate Bank in California — injected hefty doses of uncertainty into the financial system. The $209 billion-asset Silicon Valley Bank's reliance on deposits from risky technology startups brought it down, while the $110 billion-asset Signature and the $11 billion-asset Silvergate tumbled following forays into the cryptocurrency market.

Robert Bolton, president of bank investor Iron Bay Capital, said in an interview that the problems at the failed banks appeared isolated. However, they nevertheless added to recession worries and would likely galvanize bankers to grow increasingly selective with their lending decisions.

"It's a safe bet the banks will become more conservative," he said.

The ABA's credit index found that economists expect both consumer and business credit quality to deteriorate this quarter and next. They also expect banks will pull back on lending to avoid potential pockets of weakness, including consumer loans and commercial real estate.

The association's Consumer Credit Index, a sub-category, fell 7.9 points to 5.8 from the prior quarter. Bank economists polled by the ABA expect both consumer loan availability and credit quality to decline. During recessions, job losses tend to accumulate and consumers' collective ability to make loan payments often weakens.

The ABA's Business Credit Index, meanwhile, slid 5.6 points from January to a reading of 5.8. The economists expect that overall credit conditions for businesses will continue to soften over the next two quarters.

Piper Sandler analysts Scott Siefer and Brendan Nosal said in a report this week that the latest Fed data – covering conditions through the end of March – showed that lending already slowed late in the first quarter.

Over the last two weeks of March, total industry loans were down 0.9%, "which represents the worst two-week stretch we can recall," the Piper Sandler analysts said. They noted that 70% of the decline in loans over that period came from community and regional banks. What's more, they added, every loan category other than credit cards fell in the final week of March, "which also represents the broadest deterioration we can recall…Loan contraction is now becoming a more visible pressure point."

This comes atop deposit losses. Customers, nervous about bank runs that hastened the recent failures, have pulled some of their money out of banks in favor of perceived safe havens such as U.S. Treasuries.

The Fed data showed total industry deposits dropped another $65 billion in the last week of March. That brought the total deposit loss to $411 billion from levels prior to the bank failure disruption that arrived in the second week of March, according to Piper Sandler's tally. But the most recent data suggest that the pace of deposit outflows slowed by two-thirds in the final week of March.

Deposits "stabilized in the most recent week, which we consider a positive," Siefers and Nosal said.