Could Business Failures Cause A Banking Crisis?

Could Business Failures Cause A Banking Crisis?

Executive Summary

As we wrote in a report in November, rising levels of corporate debt have left businesses more susceptible to economic shocks. That shock now appears to be upon us, with the economy grinding to a halt in an effort to slow the spread of COVID-19. In this report, we delve into whether or not banks would be able to handle a potential wave of defaults in the business sector. While banks' exposure to business debt stands at or near all-time highs, regulatory changes in the aftermath of the Great Recession have helped ensure banks are well capitalized. Our analysis suggests that even if delinquency rates in the business sector were to double the highest rates seen since 1990, banks would still remain ‘well capitalized' under the current regulatory definition. Of course, this level of economic deterioration would put stress on other portions of banks' balance sheets, but we still seem to be a long way away from a shortfall of capital in the nation's banking system.

 

How Exposed Are Banks to the Non-Financial Business Sector?

We have written a number of reports over the past year or so about the financial health of the nonfinancial business sector. We concluded in a report in November that corporate debt would probably not be the catalyst of an economy-wide downturn in the foreseeable future. However, we thought that any growth-slowing shock could lead to financial stress in the non-financial business sector that could then exacerbate the downturn.

That shock, in the form of the COVID-19 pandemic, is now upon us. The U.S. recession that now appears to be in train likely will lead to a wave of failures in the business sector, which would then cause an increase in non-performing loans among the nation's banks. In that regard, the drop in the bank subcomponent of the S&P 500 index, which is approaching 45% since the beginning of the year, suggests that tough times are ahead for the nation's banking sector. Could the banking system be brought to its knees again á la 2008-09, potentially leading to another financial crisis/Great Recession?

To shed some light on that question, we calculated the amount of exposure that the commercial banking system in the United States has to the non-financial business sector. Specifically, we looked at loans by American banks to the business sector as well as banks' holdings of corporate bonds, commercial mortgages and commercial mortgage-backed securities (CMBS). We expressed these holdings as a percent of banks' total financial assets (Figure 1). As a point of reference, we also calculated bank exposure to the residential property sector (i.e., residential mortgages, residential mortgage-backed securities (MBS) and home equity lines of credit).

The good news is that bank exposure to the non-financial business sector at present is significantly below its exposure to the residential property sector at the height of the housing bubble a decade ago. That is, assets secured by residential real estate accounted for 44% of the assets of the commercial banking system at the height of the housing bubble in 2006. Bank exposure to the nonfinancial business sector today accounts for 26% to 34% of banking system assets. 1

The bad news is that bank exposure to the business sector has been trending higher over the past ten years or so. Bank exposure to the non-financial business sector currently stands at an all-time high under the more inclusive measure of business loans described in Footnote 1 and near an alltime high under the less inclusive measure. Would a wave of corporate bankruptcies, should one transpire, be problematic for the commercial banking system in the United States? How big could a "wave" of corporate defaults potentially be?

Source: Federal Reserve Board, Federal Deposit Insurance Corporation and Wells Fargo Securities

We start by turning to data from the Federal Deposit Insurance Corporation (FDIC), which begin in 1991. As shown in Figure 2, there have been cycles in the non-current status of business loans, which not surprisingly coincide with the business cycle. That is, the proportion of business loans in non-current status moves up during recessions and their immediate aftermath, and it recedes during expansions.2

The non-current rate of business loans rose to over 2% following the relatively mild downturn in 2001, and it closed in on 4% following the Great Recession. The rate exceeded 5% at the beginning of our time series in 1991 as the U.S. economy was emerging from recession that was caused, at least in part, by a severe downturn in the nation's commercial real estate sector. Indeed, the noncurrent rate of loans that were secured by commercial real estate rose to nearly 7% during that period. If the non-current rate today were to match previous cycles, then the absolute amount of delinquent business loans would rise to somewhere between $80 billion (2.2%) and $200 billion (5.4%).

The banking system's ability to absorb such a loss ultimately depends on the capital buffers that banks hold. In that regard, the "first line of defense" that banks tap when losses begin to mount is common equity Tier 1 (CET1) capital. Due to regulations that were put in place following the 2008 financial crisis, banks have been building up their capital buffers. Today, the largest 25 banks in the United States, which collectively account for 87% of the banking system's financial assets, hold $1.1 trillion of CET1 capital. This absolute amount represents nearly 12% of the risk-weighted assets (RWA) of those institutions.3

Banks need to hold a minimum of 4.5% of their RWA in CET1 capital, and an extra 2.5% for the bank to be considered "well capitalized" by regulators. As a group, therefore, these 25 largest banks could write off about $460 billion of loans, and still be considered "well capitalized." If banks wrote off this amount of loans, then the proportion of C&I loans and commercial mortgages that would be in non-current status would spike to more than 12%, significantly higher than anything that has been experienced in the U.S. economy in recent history. Of course, a wave of bankruptcies would lead to higher unemployment, which would also push up the non-current status of household loans. Nevertheless, we still seem to be a long way away from a shortfall of capital in the nation's banking system.

 

Conclusion

Increasing debt levels over the current cycle have left the business sector in poor financial health. Fortunately, banks' increased capital levels since the Great Recession put them in a good position to weather a potential wave of defaults in the business sector. While the depth and the duration of the impending economic contraction remain highly uncertain, we believe that the nation's banking sector should be able to withstand the storm.

 


Source: FxStreet

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