Question:  

Do you expect the volatility in regional banks to continue?

Answer: 

 This year we’ve experienced three of the four largest ever U.S. bank failures. Most recently, First Republic Bank was taken over by the Federal Deposit Insurance Corporation (FDIC) and sold to JP Morgan. The share prices of other small regional banks share prices decline, and the proposed merger between TD Bank and First Horizon was called off. Volatility in regional banks is likely to continue into the near future. Headlines of bank failures are unsettling, so let’s put this into perspective for what it means to the economy as a whole and various asset classes. 

Small Business

A healthy banking system is important for economic growth. Recent events and higher interest rates will cause lending standards to be tighter and will help take the edge off of inflationary pressures. The recent turmoil in regional banks is caused primarily by poor strategy and risk management, resulting in greater impact on business lending rather than on consumer lending. 

The Fed has increased the Fed funds rate in their last ten consecutive meetings pushing costs higher for credit cards, auto loans, home loans and borrowing costs overall putting pressure on small businesses going forward. Small businesses rely heavily on regional and smaller banks for financing. This area of the economy makes up approximately 48% of total employment and generates roughly 44% of total economic activity. A slowdown in small businesses will be a headwind for economic growth going forward. 

Consumer 

Don’t overestimate the impact of tighter lending standards and a potential slowdown in small business activity though. Remember that consumer spending makes up ~ 70% of Gross Domestic Product (GDP) and is the main driver of the economy. Until a significant slowdown in the labor market occurs healthy consumer spending will offset weakness in business investment. 

The Fed and regulators have stepped in to shore up confidence and provide liquidity to banks during the recent turmoil. The market is anticipating interest rate cuts and/or easing by June 20, 2024. In the past, the Fed has come to the rescue, cutting interest rates to mitigate or offset the downward pressure on growth. With the current economic backdrop of continued inflation, the Fed doesn’t have that luxury of cutting rates at the moment. It would take a significant deterioration in economic conditions for interest rates to be reduced. According to Fed Chairman Powell, “conditions in (the banking) sector have broadly improved since early March, and the U.S. banking system is sound and resilient,” and that “the case of avoiding a recession is in my view more likely than that of having a recession.” The Fed appears more optimistic about the banking sector and the economy. 

The tug-of-war between the markets and the Fed will likely continue with debt ceiling negotiations coming to a head and House Republicans looking for spending cuts in the upcoming budget. A challenging economic backdrop and tighter lending standards could bring a mild recession in the second half of this year. Fed Chair Jerome Powell estimated that the expected tightening would be roughly equivalent to an additional twenty-five basis point rate hike.

Regional banking turmoil continues to drive headlines. However, consolidation in the regional banking sector could be a tailwind for larger banks that are typically better insulated to the risks regional banks face. Or, as Warren Buffet said, “Banking is a very good business if you don’t do anything dumb.” It is important to recognize that the economy and various sectors of the stock market can differ. Stay focused and plan accordingly. 

Source: FactSet, as of 5/4/2023.