While the ups and downs of economic cycles are a fact of life for businesses and consumers, the reality is that no two downturns are exactly alike. A study published by the Federal Reserve a few years ago highlighted the difference between recessions categorized as "severe," marked by an average change in real GDP of -3.4%, and those defined as "mild" or "moderate," where the trend in real GDP ranged from -0.6% to -1.1%.
Recently, the banking system has come under pressure from the regulatory seizures of two prominent banks. In my view, this was due to issues with the banks' specific business models and balance sheets — and not a systemic problem. That said, the need for banks to prioritize liquidity, asset diversification, and risk management is more important than ever.
Based on recent economic indicators and various governmental and academic analyses, it appears that we may be able to avoid a deep downturn of the kind we saw in the Great Financial Crisis. Treasury Secretary Janet Yellen noted in early February, "What I see is a path in which inflation is declining significantly and the economy is remaining strong." In fact, the U.S. economy added 517,000 jobs in January, and unemployment fell to 3.4%, the lowest rate since May 1969.
While higher interest rates are expected to cause a decline in existing home sales this year, the realtor industry forecasts existing home price appreciation to remain in positive territory. Some Federal government initiatives — including the 2022 Inflation Reduction Act, with its focus on energy and climate infrastructure investments, and the CHIPS and Science Act, which supports the domestic semiconductor supply chain, are likely to stimulate business activity for the next several years.
The long-term fiscal stimulus will be accompanied by sharply higher defense spending globally, which will increase demand for the U.S. defense sector. In addition, the severe supply chain disruption that occurred in recent years has led many U.S. producers to consider higher inventory levels, nearshoring and reshoring, all of which may ultimately benefit domestic suppliers.
The International Monetary Fund also has suggested that, while the global economy still faces major headwinds, the slowdown may be less pronounced than previously anticipated. The IMF now expects the world economy to grow by 2.9% this year, up from the 2.7% rate predicted in October. The mild winter reduced energy sector pressures, resulting in a far stronger near-term outlook for the European economy. Better conditions in Europe and China's progression into a post-COVID-19 economy later this year both bode well for global growth prospects.
If these and other economic "vital signs" are accurate predictors, we likely will not experience a broad, deep recession — at least not in the U.S.
That said, some geographic regions and industry sectors will suffer greater economic hardships than others. Prudent bankers are always prepared for the possibility of a recession, regardless of the forecast. Our customers, employees, stockholders, and communities deserve — and our regulators will demand — nothing less than a responsible, risk-aware approach to navigating a downturn. At the same time, our stakeholders would be ill-served by an overly constrictive approach to credit, which would deprive individuals, businesses and communities of vital financial resources and could deepen the impact of a recession or forestall a future economic recovery.
The banking industry is clearly considering the possibility of a steep downturn. A Federal Reserve survey of senior loan officers, in the 2022 fourth quarter, asked how their banks' lending standards would change in the event of a recession. A large majority of these bankers said they would "somewhat" or "substantially" tighten lending standards for construction and development loans (79%), commercial real estate loans (86%) and residential mortgages (74%).
In addition, sharply higher funding costs have raised the cost of credit for borrowers. The combination of tighter credit standards and higher cost of credit could restrict credit well into 2023.
That said, credit tightening does not appear to be severe, nor is it widespread — at least not yet. The same Federal Reserve survey asked lenders how their banks' credit standards for C&I loans or credit lines had changed over the past three months; 50% of large banks and 67% of other banks said their credit standards were "unchanged."
Healthy borrowers have clear access to credit and should continue to have this access, as long the economy avoids a broad-based downturn or sharp change in conditions. Given the current economic outlook, I believe the situation calls for a measured response to lending by banks, characterized by three key strategies. While the discussion is focused mainly on commercial lending activities, I believe the broad principles apply to consumer and residential mortgage lending as well.
First, maintain appropriate underwriting discipline, taking into account the factors affecting different segments of the economy. For example, central business district office properties or "big box" retailers may feel the impact of a downturn in ways that life sciences-related businesses, which are being bolstered by investments in new mRNA treatments, may not. Credit structures should remain prudent across the board, with additional conservatism in higher-risk segments.
Second, manage loan portfolios to avoid concentrations in any sector, property type or geography. It is impossible to fully predict precisely where weakness will develop. Covid-19 boosted the fortunes of second-home focused geographies and outdoor recreation-focused businesses while punishing many urban central business districts. Don't assume you know what is coming. As a bank operating in the Middle Atlantic region, OceanFirst is fortunate to serve a generally robust and resilient market. We also benefit from a diverse group of corporate customers, arrayed along the Northeast corridor from Baltimore to Boston.
Our diversity in geographic distribution, sector concentrations and collateral types provides some protection against a sharp, concentrated correction. Every bank should assess its own exposure and maintain an appropriately diverse book of business.
Third, stay actively engaged with your customers. Sharing perspectives and observations about the economy and marketplace will help your customers make better financial decisions — and help the bank anticipate credit quality issues. For example, we have advised our business borrowers, many of which are middle market companies, to avoid becoming over-leveraged and to stay liquid. At the same time, however, we suggest that they not be panicked to the extent that they stop investing in their businesses. Often, a downturn may create opportunities to expand more cost-effectively, as equipment or facilities become less expensive, or acquisition prospects become more economical.
In summary, I believe that a prudent, reasonable approach to comprehensive credit risk management can protect banks against the impact of a recession while continuing to serve and grow with our clients. Our industry has the capacity to prudently support the economy while refraining from the actions that increase economic volatility, prolong a downturn, and threaten an eventual economic rebound.
