The Federal Reserve has warned that the recent banking turmoil in the U.S. could trigger a credit crunch, posing a risk to the economy.
According to the Fed’s Senior Loan Officer Opinion Survey, banks are anticipating stricter lending standards for the remaining part of 2023 due to worries about a recession and deposit outflows triggered by Silicon Valley Bank’s failure. The major banks, with assets worth $250 billion or more, are attributing the possible credit restriction to an ambiguous economic situation.
Although regulators and officials have taken decisive actions to tackle the crises, worries about the economic outlook, credit quality, and funding liquidity could cause banks and other financial institutions to reduce the supply of credit to the economy. Consequently, there could be a sharp contraction in credit availability that would increase the cost of funding for businesses and households, ultimately resulting in a slowdown of economic activity.
The Federal Reserve has identified credit crunch as one of the most significant current risks to the financial system, despite not being the most likely scenario. Financial Times reports that this reflects mounting concerns about the potential impact of recent banking turmoil on the economy, making it one of the most turbulent times in the US since the global financial crisis of 2008.
Austan Goolsbee, President of the Federal Reserve Bank of Chicago, has warned that a credit squeeze could lead to a recession. This warning comes as the U.S. faces a possible debt default, as the White House and Congress are yet to agree on raising the borrowing limit of $31.4 trillion. To avoid a catastrophic impact on the economy and markets, a deal must be reached by early June.
The Federal Reserve has warned about potential vulnerabilities in the commercial real estate market, indicating that a decline in property prices could result in losses for creditors holding commercial real estate debt. To mitigate these risks, Financial Times reports that the central bank will increase its monitoring of commercial real estate loans and implement more rigorous examination procedures for banks with high levels of exposure to this sector.
Banks resilient in the face of interest rate hike
While the Fed’s financial stability report highlighted potential risks to the financial system from the credit crunch and the commercial real estate sector, it also brought some good news.
The Fed report indicates that the household sector might be less vulnerable to economic shocks, thanks to moderate borrowing levels and the majority of household debt owed by those with higher credit scores. Additionally, the Fed has expressed confidence that most banks could cope with tighter monetary policy.
Despite the turbulence experienced by banks in March, the Fed’s financial stability report suggests that most banks have a solid financial foundation to withstand potential challenges resulting from higher interest rates.
The report indicates that most banks have high capital levels and moderate exposure to interest rate risk. Moreover, as of the fourth quarter of 2022, banks in the US, particularly those considered globally systemically important, were found to be well capitalized, which positions them to navigate any uncertainties in the near future.
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