The data show the challenges of the banking system in the middle of a confidence crisis. However, as many analysts point out, this isn’t necessarily the main factor that dictates the risk of a credit crunch.
Deposit flight is certainly an important risk. Many regional banks will have to cut lending to families and businesses as deposits shrink, but in the United States, bank loans are less than 19 percent of corporate credit, according to the International Monetary Fund, while in the euro area, they’re more than 80 percent.
What will generate a credit crunch is the destruction of capital in the asset base of most lenders. The slump in mark-to-market valuations of all asset classes from loans to investments is what will ultimately drive an inevitable credit contraction.
Credit standards have tightened significantly already, and the credit impulse of the economy, both in the United States and the euro area, has deteriorated rapidly, according to the respective Bloomberg indices. Both are below the March 2021 low.
We must remember that tightening of credit standards was already a reality before Silicon Valley Bank’s demise. But the reality check of capital destruction in the financial system’s asset base is far from done.
Startups will most likely see the most severe crunch in financing, as the tech bubble burst adds to the asset base capital destruction in private equity and venture capital firms, which have delayed the required write-downs all they could and face a sobering reality check. Our internal estimate of capital destruction in the asset base of banks and private equity firms is between a 15 percent to 25 percent wipeout, which is consistent with the average decline in market value over the October 2021 to March 2023 period.
Real estate investments all over the United States and Europe require a significant reevaluation now that real estate has underperformed the market for 18 months, according to Morgan Stanley. The optimistic valuations of real estate and corporate investments in banks’ balance sheets will require a significant analysis and subsequent write-off that will lead to much tighter credit standards and stringent investment conditions.
Capital destruction tends to be forgotten in a world used to constant central bank easing, but it’s likely to be the main source of the strangling of credit to families and businesses, as banks and private equity firms deal with the loss of value and weakening earnings and cash flow from investments made at elevated valuations and high prices.
The main challenge this time is that capital destruction is happening in almost every part of the lenders’ asset base, from the allegedly low-risk part—sovereign bond portfolios—to the aggressively priced investments in volatile businesses and bull-market valuations of corporate and venture capital investments.
The profitable asset part of banks will likely require important provisions for nonperforming loans, a subject that was raised by the Federal Reserve and the European Central Bank months before the banking crisis. Furthermore, as governments will likely blame the recent collapses on lack of regulation again, it’s extremely likely that new rules will be imposed demanding that banks book large provisions recognizing losses on the loan book ahead of time.
Even if we assume a modest impact on banks’ balance sheets, the combination of higher rates, declining optimism about the economy, and the slump in equity, private investments, and bond valuations is going to inevitably lead to a massive crunch in access to credit and financing.
It’s more than banks. The crunch will come from private direct middle market loans and a decline in high-yield bond demand, while institutional leveraged loans will likely fall as access to leverage is more expensive and challenging, and investment grade bonds may likely continue to see strong demand but at higher costs.
The question isn’t when there will be a credit crunch, but how large and for how long. Considering the size of the famous “bubble of everything” and its slow implosion, it may last for a couple of years even with a central bank pivot, because, by now, a reverse in monetary policy may only zombify the financial system.
