DANIEL VAUGHAN: What follows bank failures? A credit crunch.

 March 20, 2023

Another weekend goes by with a major bank failure attached to it. Credit Suisse, the 167-year-old institution and once the second-largest bank on earth, is no more. After trading near a peak of $70 a share in 2007, Credit Suisse got sold to its competitor UBS for $0.82 a share, a shell of its former glory. Now everyone turns their attention from Switzerland back to the United States, where the fate of First Republic Bank looms.

Joe Biden claimed he saved banking and Silicon Valley a week ago. Yet, we're still working through the ripple effects of increasing interest rates on the economy. Biden's victory lap would be like George W. Bush hanging a "Mission Accomplished" banner on the first week of the war. Our economic crisis isn't ending; the problems are only beginning.

As of the publishing time of this column, we have yet to determine the fate of First Republic Bank. Reporting suggests it could get bought out too, but time will see. After another S&P downgrade, expectations are for another sale, which would bring us to five banks gone. Whether that happens or not, markets have shifted towards a much tighter environment. That brings us to the next economic challenge: a credit crunch.

The looming credit crunch.

A credit crunch is "a decline in lending activity by financial institutions brought on by a sudden shortage of funds. Often an extension of a recession, a credit crunch makes it nearly impossible for companies to borrow because lenders are scared of bankruptcies or defaults, resulting in higher rates."

We encountered this in 2008 when the housing crisis led to banks not wanting to lend more to homebuyers or anyone. A credit crunch leads to harsher lending standards for businesses and individuals and slows economic growth. The definition connects a credit crunch to a recession because the two often go hand-in-hand.

With our multi-year-long inflation issue, the Federal Reserve has tried to create a slight credit crunch by increasing rates. The Fed wanted slow economic growth to control the rate of inflation. Every investor's mantra in these moments is that the Federal Reserve will raise rates until they break something. Bank failures are a surefire sign the Fed has broken something.

The bank runs tighten economic conditions.

We've experienced a rapid tightening of credit conditions in only two weeks. As people have fled small and mid-sized banks, they take their deposits to larger institutions. With fewer deposits, these small and mid-sized banks can't loan or invest as much money to make a profit off deposits.

Yahoo Finance reports, "Rattled by runs on regional US banks and wild gyrations in stocks and bonds, bankers abandoned attempts to raise new funding for their corporate clients. Not a single investment-grade company sold bonds in the US market last week, marking the first sign of what's set to be a broad-based hit to the provision of credit across the economy."

Apollo Global Management, an asset investment firm, estimates that the "events this past week correspond to a 1.5% increase in the Fed funds rate. In other words, over the past week, monetary conditions have tightened to a degree where the risks of a sharper slowdown in the economy have increased."

Put another way, the Federal Reserve was only planning on raising rates by 25 basis points this upcoming week. The bank run contagion resulted in the equivalent of 150 basis points of tightening in a single week. We've witnessed one of the most aggressive rate-tightening cycles in US history over the last year, but nothing like that has happened.

More expensive credit for everyone else.

Where does that leave everyone else? It means business, home, auto loans, and credit cards have become more expensive in the last two weeks. We were already experiencing higher interest rates for those items. The flight to safety from smaller banks to the largest has severely clamped down on the US economy.

We may get past this moment of turmoil with banks relatively unscathed. But that won't stop the growing pressures of a credit crunch on the broader economy. As the cost of credit dramatically increases, the stresses it induces on individuals and businesses will be intense. Much like inflation, there's an amount of time people can take that, but after a while, it drags on everyone.

In 2008, we witnessed a similar dynamic with the collapse of Bear Stearns in March of that year. The wheels came off the cart after the credit crunch grew, and Lehman Brothers collapsed in September. That's not a guarantee that we will follow a similar timeline. But the pressures building on the credit side are growing and will exert more power on markets than before.

We're out of the frying pan and into the fire.

" A free people [claim] their rights, as derived from the laws of nature."
Thomas Jefferson
© 2015 - 2024 Conservative Institute. All Rights Reserved.