Banks and the Next Recession

A number of us economists are very worried about the prospects of recession. Most of us are not actually forecasting a recession, but on average we figure the odds are about 30 percent that we’ll have a recession next year. What should banks do differently because of this risk?

Recessions have some common traits but also have twists and turns that make each episode unique. Bankers planning for 2012 should consider the greatest downside risk to come from the European financial crisis. Some parts of bank planning should reflect the general possibility of a downturn, and some parts should be specific to the European risk.

Recessions most obviously bring credit quality problems to banks but also changes in the balance sheet. Loan demand weakens during a recession. Certainly commercial lending demand would decline as credit-worthy borrowers hunker down. Although real estate lending usually falls in recession, current loan production is so small that there’s not a lot of downside in that category. Consumer lending is likely to fall as well.

Deposits typically grow rapidly as the economy pulls out of recession, thanks to Federal Reserve efforts to stimulate the recovery. This time round, however, don’t expect massive Fed policy changes, due to already-low interest rates and nervousness about the past Fed actions proving inflationary.

Now let’s turn to the credit quality problem. Banks should think about specific problems triggered by a European recession, as well as general weakness caused by the overall downturn. The first issue applies to companies that are selling a good bit of their products or services to European customers. Remember that foreign trades tend to be more cyclical than the overall economy, so if European spending falls by one percent, our exports to Europe could fall by two percent.

When assessing which companies have significant exposure to Europe, don’t limit analysis to the company’s own sales. Many businesses sell components to other businesses that end up being sold in Europe. So a company may have significant exposure overseas even if its largest customers are American corporations. Here’s another case where the importance of knowing the customer is central to credit quality.

After reviewing the companies that have European exposure, the bank’s credit officers should think about the impact of a recession more generally. Even if you are not banking the firms with the biggest European exposure, those businesses may be part of your community’s economy. For the United States as a whole, sales to Europe account for 22 percent of all exports. Despite our trade deficit, exports are a big deal to the overall United States economy, accounting for two trillion dollars of our 15 trillion dollar economy.

Your own state, however, may have a smaller or larger reliance on exports, and specifically on exports to Europe. For example, Utah has the highest exposure to Europe as a percentage of their economy, exporting about 5.6 percent of the state’s GDP to the Continent. Hawaii, on the other hand, exports less than 0.2 percent of its GDP to Europe. The statistics are not perfect, but they do give a general idea of a state’s risk. (See the chart showing state exports to Europe in the previous blog post.)

Despite all this talk about recession, a downturn is not the most likely scenario. The odds are that we will skate through. However, a risk this big must be addressed by bank leadership.