Could a recession rerun be in the cards for banks?
For all the fears and hand wringing sparked by the Great Recession, banks have weathered few if any financial tremors since it faded into the rear view. All in all, it’s been an ideal opportunity for the financial services industry to learn, adjust and adapt. Or has it?
Claudio Borio, a chief economist with the Bank of International Settlements (BIS), states in the most recent BIS quarterly report that “further turbulence is likely at some point given that markets in advanced economies are overstretched, financial conditions are too easy and debt, globally, is too high.”
He adds: “With interest rates still unusually low and central banks’ balance sheets still bloated as never before, there is little left in the medicine chest to nurse the patient back to health or care for him in case of a relapse.”
In other words, central banks may lack effective defenses to combat the next financial crisis. And that could mean a huge, dangerous déjà vu if any kind of unforeseen instability rocks the banking world.
Debt is hampering the ability of central banks to react and any number of wild cards could threaten the fragile global economic recovery, a slow healing process that has taken a decade from the 2008 meltdown.
What do these dark clouds portend for U.S. institutions and how might they prepare for the next crisis? Milton Ezrati, chief economist for marketing agency Vested, is concerned about leveraged loans and banks’ exposure to emerging market economies like Turkey, which is specifically cited in the BIS report. “Turkey was heading down the primrose path to disaster long before the BIS report.”
“There’s going to be a crisis,” says Ezrati, “but I don’t know if it will pan out the way the BIS says it will.”
There are other tangible reasons to be concerned about U.S. and global economic conditions. The Federal Reserve is eyeing more interest-rate hikes to curb inflation after raising the federal funds rate to a range of 2 to 2.25 percent in late September, the highest level in a decade. The bank is also closely watching the growing trade conflict between Washington, China, Europe and other countries.
The Fed uses rate hikes as tools to brake overheated lending and economic activity. Goldman Sachs economists predict the central bank may hike rates four times next year, reports Reuters. Is the Fed’s tightening going to hurt or help banks?
Like most Fed actions, rate hikes work as imprecise instruments for guiding the U.S. economy along a relatively low-inflation, higher-growth course. The rate moves can overshoot or undershoot economic targets. There’s also no Fed acknowledgement of what impact, if any, a massive round of new trade tariffs will have on the world’s largest economies.
Although Fed Chairman Jerome Powell said the bank was hearing “a rising chorus of concerns from businesses all over the country” about the trade war, he didn’t say what impact it’s had on U.S. banking or overall economic growth, which the Fed forecasts will top 3 percent this year with inflation hovering around 2 percent annually.
Another benchmark to watch is the price of oil, which can act as a harbinger of rising inflation. Crude futures recently topped the $72-a-barrel mark, the highest price since 2014. Higher oil prices are particularly worrisome for emerging economies reliant upon imported energy as well as Europe, China and Japan.
A combination of higher inflation, trade wars, increased sovereign debt (the U.S. will soon dole out more on interest than defense spending) and potentially slower economic growth equals a perfect storm for the global scene.
While Erzati notes that megabanks have the most exposure to leverage and emerging markets, he offers this advice for varying segments and scenarios:
- Emerging markets. “The best defense is diversification and risk control. If you’re overexposed to China (now engaged in a trade conflict with the U.S.), choose Cambodia or Indonesia, which are not impacted.”
- Leveraged loans. “Also seek diversification and offload them from balance sheets.”
- Smaller banks. “They should avoid emerging markets and avoid doing business with `too big to fail’ banks.”
Overall, “the real threat in a crisis isn’t currencies (devaluation), it’s default,” he says. “Consider floating rate versus fixed income (securities) to protect your shareholders.”
Granted, the next recession won’t necessarily resemble 2008. Yet it’s fair to question whether regulators and banking leaders are truly braced in the near term for any potential global blow-up.
Yet as Ezrati observes in a recent blog, that past is not necessarily prologue.
“The kind of quiet thoughtfulness and competence that effectively quelled the 1980s crisis eluded Washington ten years ago,” he writes. “That fact might well guide official behavior next time.”
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John F. Wasik has written 17 books and contributed to The New York Times, Wall Street Journal, Forbes, Financial Planning, Bloomberg and Reuters. His firm JK Enterprises provides editing and writing services for financial services firms. He has spoken about investing, innovation and creativity across North America.