Economic Slowdowns: So Far So Good for the Banks

At this date, it`s fairly clear that the U.S. manufacturing sector is in a recession. It`s what I call a 15% to 20% recession, since that is the size of manufacturing relative to the total economy. (When I graduated from college, it was more like 50%.) The services sector, education, health care, entertainment, and the like, have not yet slowed down much, but it`s likely they will get a little softer.How is banking fairing in this slowing economic environment? First, with great prescience, banks began tightening credit standards more than two years ago and were well ahead of the Federal Reserve Board in trying to put the brakes on excessive capital spending. Some folks, in fact, now blame the banking system for the drop in manufacturing activity, which has resulted in the pain of firing people and cutting purchase revenues. Fed Chairman Alan Greenspan even went so far as to caution bankers not to be too tight with their credit.

From his standpoint as a bank regulator, that is an unusual statement, and just goes to show once again there exists conflicts between the Fed`s economic and monetary policymaking duties and its responsibility to monitor bank safety and soundness. In fact, the banks did blow the whistle on the excesses in the manufacturing area (particularly with regard to high-tech and telecom companies), action that will surely make the current economic slowdown shorter in duration and less severe than it would have been if banks had not acted so promptly. Bankers, remembering the 1987-1992 period, responded the way they are supposed to in a free economy, thus benefiting the banking system as well as the nation`s economy. Despite their relatively quick action, the slowdown will have an effect on bank profits. As in all recessions, the banks` bottom lines will reflect the economy rather closely. However, the loan problems of the `80s and `90s, excessive lending to commercial real estate projects, will not be the major difficulty it was in the last recession for most banks. Also high-risk “mezzanine” lending does not seem to be as widespread and will not present the same problems it did a decade ago. Still, overall loan quality will continue to deteriorate and, as a lagging indicator, will get worse for at least the rest of this year and probably half of next year. Profits will be down since loan problems will increase for almost all banks. Just how far south they`ll go depends to a substantial extent on the length of this downturn. Loans go bad when borrowers are exposed to a lengthy period (over one year) of slow economic activity. At this juncture, no one can predict the length of this recession or whether it will spread to the rest of the economy. My guess is we will see a real upswing by early 2002, as the service economy probably still has some slowing ahead. How hard this period of economic distress will be on individual banks will depend on the credit lending skills and the talents of risk managers. Those banks that have had concentrations of loans in one sector, such as telecoms and high tech, will see the worst results. Concentrations in consumer credit cards and subprime lending will also be potentially weak areas.

The results for well-managed banks will be only a drop in profits, not losses. For those few who have high-risk operations, the slowdown may yet prove to be fatal. By the middle of 2002, those institutions that that not taken proper precautions to shore up capital and mitigate their credit risk will be apparent. But I believe that the future is promising for most banks. If banks can survive this period without mass failures and with average profit reductions, it should result in the industry being held in better esteem by the markets with better price/earnings ratios. Today that P/E ratio is about 50%-55% of the Dow Jones Industrial averageu00e2u20ac”so no matter what, there`s lots of room for improvement.