Are bank failures doing the Fed's job for it?

Emergency Fed lending to banks is approaching $300 billion, according to the central bank's H.4.1 release, and that has undone months of quantitative tightening in a matter of days. The weekend that brought down Silicon Valley Bank and Signature Bank has left Federal Reserve policymakers with a very different set of sums ahead of their March FOMC meeting. Wall Street has settled on a new theory, which holds that the regional banking crisis has done the Fed's tightening for it. If small and mid-sized banks pull back to protect their balance sheets, the resulting squeeze on credit could slow demand more effectively than further rate rises.

That squeeze runs straight into the real economy. Regional and community banks provide roughly sixty per cent of commercial real estate lending in America, fifty per cent of commercial and industrial loans and eighty per cent of farm debt.

Two weeks that changed the sums

The backdrop has shifted with startling speed. Two weeks ago Jerome Powell was preparing markets for half-point increases. Since then two American banks have failed, the Swiss authorities have pushed Credit Suisse into a takeover by UBS, and on Sunday the Fed and five other central banks moved their dollar swap operations to a daily schedule. Futures markets now expect either a quarter-point rise or a pause when the committee announces its decision on Wednesday, with cuts priced for later in the year.

The European Central Bank has already shown one way through the dilemma. Last Thursday, in the middle of the Credit Suisse scare, it raised rates by half a point as planned, arguing that liquidity tools could deal with bank stress while interest rates dealt with inflation. The Fed is under pressure to make the same separation, and under equal pressure from those who think the banking system cannot take another increase.

Banks stop lending

These banks are not collapsing one after another, but they are frightened. Facing continued deposit flight and closer scrutiny from regulators, their credit committees are pulling back at once.

Lending standards are being tightened toward historic extremes and loan-to-value ratios cut, while credit lines to small and mid-sized firms are being cut or not renewed. That withdrawal of credit puts an immediate brake on hiring and on business investment and construction.

The pullback builds on a tightening that was already under way. The Fed's Senior Loan Officer Opinion Survey showed standards on business loans rising through 2022, well before any bank failed, as lenders braced for recession. Deposit flight adds a second motive, because a bank losing funding must shrink its assets and new loans are the easiest thing to stop making. The weekly H.8 figures on commercial bank balance sheets, which separate small banks from large ones, will show how fast that is happening.

The arithmetic of a shrinking bank is unforgiving. A lender that loses deposits must replace them with dearer funding, such as advances from the Federal Home Loan Banks or brokered deposits, or run down its assets. Replacement funding squeezes the margin on every loan, so even banks that keep their deposits will demand higher rates on new credit. Either way, the borrower pays more or gets less.

Who feels the squeeze

The damage is uneven by design. Large companies with investment-grade ratings can borrow in the bond market, and they have been able to do so throughout the turmoil. Small firms, property developers and farmers have few alternatives to a local bank, and a loan officer who declines to renew a credit line leaves them with nowhere else to go. Commercial property owners face the sharpest version, since offices were already losing value from remote working and much of their debt sits with the smaller banks now under pressure.

The winners are the largest banks and the money market funds. Depositors worried about safety have moved cash toward institutions they assume the government would never let fail, and toward funds that invest in Treasury bills. That shift strengthens the biggest lenders at the expense of the regional ones, which is the opposite of what policymakers wanted from the post-2008 rules.

A poor substitute for rate rises

Economists reckon the credit crunch is worth 50 to 100 basis points of extra rate rises. Treating bank failures as a handy stand-in for monetary policy is dangerous, though.

Rate rises are broad, visible and reversible. A credit squeeze driven by banks is patchy and hard to see, and it can suddenly get much worse.

A rate rise can be undone at the next meeting. A small business that loses its credit line, lays off staff or cancels an expansion does not reverse those decisions because the Fed changes its mind six months later. Loans once refused also tend to stay refused, since banks that have shrunk their books are slow to rebuild them.

Lessons from the early 1990s

The last American credit crunch of this kind came at the start of the 1990s. The savings and loan clean-up, heavy losses on commercial property and new capital rules pushed banks to cut lending, the economy fell into recession in 1990, and the recovery that followed was weak. The Fed ended up cutting its policy rate to 3 per cent by late 1992 to offset the drag. A squeeze centred on commercial property and small-business credit has much the same shape.

The case for leaning on the banks has some logic. Credit conditions are the channel through which higher rates are supposed to work, and a Fed that kept raising rates into a banking panic could turn a squeeze into a collapse. Pausing, and letting tighter lending do part of the job, would at least avoid compounding the shock. The weakness is that nobody can size the effect in advance, and it lands hardest on borrowers least able to find another lender.

The opposite risk also deserves a hearing. The deposit guarantees and the new lending facility may calm the panic within weeks, in which case banks could resume lending and the promised squeeze would never arrive. A Fed that stopped raising rates on that expectation would find inflation still above 5 per cent and its credibility dented.

Wednesday's statement and the committee's new projections will show how much weight officials now give to credit conditions, and the next loan officer survey, due in early May, will show how far banks have actually pulled back. Leaning on regional bank distress to cool inflation is a gamble. Credit crunches rarely stop at a gentle slowdown, and a freeze in bank lending could turn a hoped-for soft landing into a proper recession within the year.