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Brace for Impact: Economic Slowdown Looms as Banks Tighten the Reins on Lending

Apollo chief economist Torsten Slok warns that the economy is headed for a slowdown, and possibly a recession, as banks restrict lending amidst tighter conditions, increased interest rates, and scrutiny following recent bank failures.

In March, the collapses of Silicon Valley Bank and Signature Bank triggered a massive shift of deposits from smaller regional banks to larger banks and money market funds. Since then, capital markets have essentially closed, causing a detrimental impact on the economy, with high-yield debt and IPOs virtually disappearing.

The longer the capital markets remain closed, the greater the negative effect on the economy. However, the magnitude of this shock remains uncertain. Since the Federal Reserve raised interest rates in March 2022, deposits at large banks have declined, with nearly $600 billion being withdrawn – the largest banking sector deposit outflow on record. Slok notes that this unprecedented outflow occurred in an incredibly short timeframe.

Slok predicts that the economy will experience a slowdown in 2023, with a recession likely by the summer. The banking crisis has exposed risks for financial institutions, such as the declining value of the commercial and retail real estate and the possibility of tighter regulations. Consequently, lending is expected to decline over the next few quarters.

The economy is moving from “no landing to a hard landing,” Slok explains, due to the lagged effects of Fed rate hikes and the ongoing banking crisis. The rescue of Silicon Valley Bank and Signature Bank by the federal government has had more severe consequences than previous crises unrelated to the banking sector.

As borrowing becomes more expensive due to rate hikes, consumers and businesses are increasingly tapping into their savings. This presents challenges for companies attempting to raise capital for expansion. In response, banks will need to reorganize their balance sheets and slow down lending to both commercial and consumer borrowers.

The economy was already experiencing a slowdown before the bank collapses, with consumers and businesses withdrawing deposits. However, these bank failures accelerated the transfer of cash from smaller banks to larger, seemingly more secure institutions.

As banks now face declining asset values, increased regulatory risks, and higher funding costs, they are likely to tighten lending standards and reduce loan approvals. This could result in a contraction of growth in the broader economy, as it becomes harder for people to borrow money for credit cards and loans. In turn, this could cause a sudden stop in spending and hire by companies due to the credit freeze.

Slok believes that the combination of Fed rate hikes and the banking crisis means the U.S. economy could be in a recession by mid-2023. The Fed is unlikely to raise interest rates in May, opting instead to cut interest rates later this year in an attempt to stimulate the economy and bolster consumer and business confidence.