Source: FRB SLOOS, net % of banks reporting a tightening of standards, data from Q2 91 data covers all loan types and is market-share weighted, before Q2 91 unweighted data for C&I loans
In this cycle, the growth headwind from tighter credit conditions has emerged more slowly than expected. The large buffer of liquid savings, built up during the pandemic, is one reason. More robust banks and exceptionally strong corporate cash flows must also have played a role. The cumulative impact of reduced credit availability should be less severe too, because a decade of tight lending standards has produced an unusually small cohort of highly leveraged household and corporate borrowers. But the US economy won’t be able to shrug off this tightening cycle. At best, the deterioration in credit supply constitutes a major cyclical headwind. More likely, it will be sufficient to tip the US into recession.
“2022 was the year the fast money lost faith in the post-GFC bull market”
This won’t, though, be a repeat of the GFC, a credit crunch in the ‘real economy’. The looming danger instead is that banks’ broker-dealer subsidiaries reduce access to their balance sheets.
This is the most likely accelerant of asset market distress in 2023. The SLOOS tells us that US banks are becoming less prepared to deploy their balance sheets towards the real economy. Increased loan losses will accelerate this trend. The underappreciated danger is that, just as this is happening, banks become less willing to undertake the low-margin capital-intensive activities that lubricate the flow of collateral and leveraged position-taking in the financial system.
A HURRICANE IS COMING
The general view: there’s nothing to see here. Bank capital buffers are substantial, while reserves at the Fed – the core of banks’ high-quality liquid asset stocks – are $3 trillion (11% of the system’s non-cash assets).10
Yet Jamie Dimon, CEO of JPMorgan, disagrees. In June 2022, he suggested a hurricane is “coming our way”, alluding to the Fed’s policy of quantitative tightening (QT) and additional regulatory demands that have eaten into banks’ capital buffers (Figure 6). He warned that JPMorgan would be “very conservative with our balance sheet.” This from the financial institution with seemingly the most rock-solid balance sheet of them all.
The Fed’s own survey of US broker-dealers (Figure 7, next page) suggests the wind speed is already picking up. ‘Fast money’ investors depend heavily on dealer balance sheets. They are the conduits for the vast flows of collateral and off-balance sheet leverage upon which the former’s investment strategies rely. 2022 was the year the fast money lost faith in the post-GFC bull market.
But it wasn’t for other types of investors. The ebbing liquidity tide has exposed the most extreme sentiment-fuelled investments, as it always does. Cryptocurrency and profitless tech have already imploded. But retail investors have stayed ‘risk on’ (Figure 8). This is the main reason the correlated bond and equity drawdowns have been so orderly.
Retreat may be at hand. Short-dated USD paper yields almost 5%. Money market funds, the most direct alternative to deposit accounts at banks, now offer retail investors a rate of return last seen 15 years ago. A decade of historically low interest rates has driven a search for yield, forcing investors into more complex, illiquid asset classes and strategies. Now that there is a cash alternative offering a reasonable nominal return, the question is not if portfolio allocators de-risk, but how quickly and from what assets.
Source: Goldman Sachs Research, bank reports, % of risk-weighted assets. * GS forecasts for Q4 22 based on published Fed stress test buffers, data covers seven largest US banks 10 Goldman Sachs