The crucial role of smaller banks in the economy means that distress increases recession risks

Main Street businesses and American families may find it harder to get credit due to the turmoil in the banking sector, which is hampering economic growth and increasing the risk of a recession.

“The risk related to the SVB spark is real,” said Greg Daco, chief economist at EY-Parthenon, a strategy advisory unit of Ernst & Young LLP. The collapse of Silicon Valley Bank sparked fears among depositors that led to the failure of Signature Bank and the bailout of First Republic Bank.

“Once there is stress in a particular group of institutions, those institutions and those that share similarities will tend to be more cautious about lending,” he said. “We will probably remain in this state for a long time.”

Smaller banks are key drivers of credit growth, the fuel that drives the economy. Banks smaller than the 25 largest account for around 38% of all outstanding loans, according to Federal Reserve data. They make up 67% of commercial real estate loans.

Aggressive steps by the federal government and Wall Street to calm these fears should avert a larger crisis. But the possibility of other banks facing similar problems has prompted a sell-off in financial stocks as investors scrutinize banks’ solvency. This, in turn, fueled public concerns about the safety of deposits and the size of unrealized losses.

Smaller banks are likely to respond by tightening standards and slowing lending to increase capital ratios, said Torsten Slok, chief economist at Apollo Global Management Inc., a private equity firm. He said the moves would bolster against the risks of more fickle depositors and volatile funding costs.

“When it’s suddenly a lot harder to get a car loan, a consumer loan, a commercial real estate mortgage just because smaller regional banks have to clean up their balance sheets,” Slok said, “then you run the risk of a lot of people making it.” I don’t get it the financing to buy that car, to buy that washing machine, and those corporate loans are taking a hit.”

He expects the US economy to enter a recession by mid-year, fueled by a slowdown in lending by smaller banks.

Until the SVB failed, Mr Slok had been anticipating a no-landing scenario, meaning the economy would continue to grow despite signs of a slowdown. “But add that risk to small and mid-sized banks and we’re headed for a hard landing,” he said, or a painful downturn.

The Silicon Valley Bank collapsed in less than two days. During that time, the stock price fell over 60% and customers attempted to withdraw $42 billion. Read how SVB became the second largest US bank failure of all time and what this means for customers going forward. Illustration: Alexandra Larkin

Mr. Daco also said he believes SVB fallout has greatly increased the likelihood of a recession and he expects a recession this year. Barring a financial crisis, he expects tighter credit and financial conditions to shave about 0.5% of GDP over the next 18 months, leaving real GDP growth essentially flat in 2023 compared to the same quarter of the year 2022. The economy on the same basis grew by 0.9% in 2022.

Goldman Sachs economists increased the probability of the economy entering a recession in the next 12 months to 35% from 25% before the SVB collapse.

Regional and smaller banks are important to the overall economy, and certain corners are even more dependent on lending from them, said Bill Adams, chief economist at Comerica Bank, a large Dallas-based regional bank.

“The banks outside of the top dozen are more focused on small business and small town and rural banking services,” he said.

Turbulence in the financial system could constrain lending through multiple channels – and ultimately weaken the economy. Basically, collapsing equity and bond markets make it more expensive to finance investments. More directly, banks could try to heal their balance sheets faster than they otherwise would, said Daniil Manaenkov, an economic forecaster at the University of Michigan.

“That means you start making less risky loans, and as you make them, you widen your spreads,” he said. “Borrowing will be a bit more expensive.” He added that some investment projects could be delayed, which could lead to fewer hirings.

In the first two months of the year, before the bank collapsed, many employees were hired. Job losses often lag behind the broader economy as employers tend to shed jobs after taking other cost-saving measures. The economy has recently shown signs of slowing, including a fall in retail spending in February.

Banks had begun tightening lending standards late last year, according to a Fed survey of senior loan officers, as soaring interest rates made it harder to find creditworthy borrowers and demand for commercial loans slacked.

The SVB fallout is likely to amplify that tightening, which bodes ill for the job market because it slows expansion and investment, said Padhraic Garvey, ING Bank’s regional research director for the Americas.

“There’s a pretty strong correlation between lending standards and unemployment,” he said.

Write to Gwynn Guilford at

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